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TOPIC 1: AGENCY LAW
• Agency exists where:
o (1) one person (a “principal”) manifests assent to another person (an “agent”)
▪ Objective test- look at the ascent from the view of a reasonable person.
o (2) that the agent shall act on the principal’s behalf [and furthering their interests] and subject to the principal’s control, and
▪ The principal has the power and right to direct the agent as to the goal of the relationship. What they shall and shall not do, and can change this.
▪ “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.
▪ 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.”
o (3) the agent manifests assent or otherwise consents so to act.
• NOTE
o It is not required that the parties intend to enter into something called an agency relationship or that they are aware of the legal consequences of an agency relationship
o A contract provision disclaiming an agency relationship could be relevant (but is not dispositive) in determining whether an agency relationship exists.
o No consideration necessary
• Agency relationships are ubiquitous (found everywhere), e.g.: Sole proprietor with an employee ,Facebook with CEO
• Sources of law: Case law (and a few states, incl. Cal., have statutory law), Restatement (case law summary that is very persuasive and influential, but not binding)
• Why do we care? Third party can hold principle liable for the actions of a 3rd party
• Reason why agency law exist: Its economic.. someone got hurt, and someone needs to pay. The principle is the lowest cost avoider..
Formation- No writing is required
• Express Agency: An agency that occurs when a principal and an agent expressly agree to enter into an agency agreement with each other. E.g. power of attorney
o Express agency contracts can be either oral or written unless the Statute of Frauds stipulates that they must be written.
• Implied Agency: There doesn’t have to be specific mention of “agency” or a written agreement for an agency relationship to exist.
o An agency relationship can be implied from the conduct of the parties.
o The extent of the agent’s authority is determined from the particular facts and circumstances of the particular situation.
Gorton v. Doty- Implied Agency Case:: Lady gave her car to coach to drive and got in a car accident. Sued car owner. Coach was then her agent because she told him that she wanted HIM to drive the car. Was not loaning him the car, rather he was acting in her spot. NOTE: Central issue is who is in the best position to avoid the problem?
A. Gay Jenson Farms Co. v. Cargill, Inc. (assuming de fcto control)
- Cargill took a lot of control over a company that it had extended credit to. The company went out of business and its debtors were trying to get at Cargill.
- Question: Was Cargill just ana gent Or actually the principle? They were the principle.
- Holding: A creditor who assumes control of his debtor’s business may become liable as principal for the acts of the debtor in connection with the business. De facto control issue
Fiduciary Duties In the Agency Relationship
• Principal’s Duties to Agent
a. The principal has a duty to reimburse or indemnify the agent for the following:
i. The terms of any contract between them (e.g., any promised payments);
ii. When the agent makes a payment within the scope of actual authority or that is beneficial to the principal unless the agent acts officiously in making the payment;
iii. When the agent suffers a loss that fairly should be borne by the principal in light of their relationship.
b. The principal has an obligation to…
i. Deal with the agent fairly and in good faith
ii. Generally cooperate with the agent
iii. Not unreasonably interfere with the agent’s performance of his or her duties
• AGENDTS DUTIES TO PRINCIPLE
a. General Rule: An agent is a fiduciary with respect to matters within the scope of his agency.
i. However, conduct by the agent that would otherwise breach the below-listed duties does not constitute a breach if the principal consents, provided that the agents acts in good faith and discloses all material facts in obtaining the consent.
Fiduciary duties that the agent owes to the principal
a. Duty of loyalty
b. Duty not to acquire a material benefit from a third party for actions taken on behalf of the principal or through the agent’s use of position
c. Duty not to act as adverse party to the principal
d. Duty to refrain from competing with the principal during agency relationship
e. Duty not to use the principal’s property for the agent’s own purposes
f. Duty to disclose information to the principal that the agent knows or has reason to know the principal wishes to have or is material to the agent’s duties to the principal
g. Duty of confidentiality (not to use or communicate confidential information of the principal for the agent’s own purposes or those of a third party)
h. Duty to act in accordance with any contract with the principal
i. Duty of care, competence, diligence
j. Duty to act only within scope of actual authority and duty to obey
k. Duty of good conduct
l. Duty to notify the principal of info that the agent knows or has reason to know the principal would want to know
Agent Duties to Principal.. boiled down to:
- Duty of loyalty.
- Duty of Care
- Duty to confidentiality
- Duty to act only withint he scope of authority.
- All of these terminate..
General Automotive Mfg. Co. V. Singer
- Facts: Machine shop had an employee on contract who received a salary plus 3% commission. He began taking machine orders and giving them to other shops for a bigger cut of the action.
- Question: Was this a violation of his fiduciary duty? Yes
- Holding: An employee will be held to his or her contractual duty of loyalty, and their fiduciary duty would forbid them from engaging in activities that are competitive with their employer.
o Why was this an agency dispute rather than a contract.. they probably preferred to collect through fiduciary duties.. the contract.. interpretation issue.. issue of remedies.. with contract law.. we get compensate damages.. Agency however.. would say.. all this stuff was discouragement..
- How could he have avoided liability? He needed to get informed consent…
- What is he was doing something wholly unrelated? Then that’s a contract issue… not an agency issue.
Consequences of Creating An Agency Relationship
• General Rule: 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.
The principal can be held liable to a third party via…
1. Actual authority
2. Apparent authority
3. Undisclosed principal
4. Ratification
5. Estoppel
Actual Authority
• 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 encompasses both what is express and implied.
o 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 express manifestations to the agent, that the principal wishes the agent so to act.
o What counts as a manifestation?
▪ If its incidental to achieving the principles objectives as the agent reasonably understands
▪ An agents interpretations of the principle manifestations is reasonable if it reflects any meaning known by the agent to be ascribed by the principle and, in the absence of any meaning known by the agent, or via context, and reasonable circumstances.
o Exception: If the parties agree otherwise, then that rule can be overridden.
Mill St. Church of Christ v. Hogan: Brother who was an employee of the church higheredhis brother to help him. His brother got hurt painting in a difficult part. The leadership at the church knew he needed help and had in a round about way said he could higher someone via suggesting an unreliable person to higher. Was there implied actual authority? Yes, see factors below. As such, the brother was an employee and could get insurance.
- Does implied actual authority exist? Look at the following factors: (1) agent must reasonably believe authority. (2) nature of the job. Was it possible to do without helkp? No. (3) The existence of prior similar practices is one of the most important factors. Specific conduct by the principal in the past.
Apparent Authority
• Definition: Apparent authority arises from the manifestations of a principal or apparent principal that give a third person the reasonable belief that an agent or other actor has authority to act on behalf of the principal or apparent principal.
• Why Use it? Apparent authority may be the basis for contract liability where an agent acts beyond the scope of their actual authority or where there is not even a true agency relationship. This is because the focus of apparent authority is on what a third party reasonably believes one person has authorized another to do.
• Protects 3rd parties. Apparent authority protects the third party who acted upon a reasonable belief traceable to manifestations of the principal or apparent principal.
• Elements: Look at the Third Parties Reasonable Belief, traceable to the Principles Manifestations. Rest section 2.03.
Elements:
a. Manifestations of principal
i. Can be words, conduct, or silence
ii. But, must be traceable to the principal (for example, through an intermediary or by the principal giving an agent a certain title or position)
b. Third party’s reasonable belief
i. Compare Opthalmic v. Paychex and Jackson v. Odenat v. Mondesir
Opthalmic Surgeons, Ltd. V. Paychex, Inc (put in a position of power): Secretary at a eye doctors office was charged with maintaining the Paychex account to handle payroll. She embezzled lots of money. Was there apparent authority? Yes because she was the person administering on behalf of the office, there is no duty by paychex to do anything else. Also the surgery office was compliant with the conduct because it took them years to find out. A principal’s silence can create the appearance of authority “when [the principal] knew or had reason to know that his silence would be relied on.”
Jackson et al vs. odenant et al. v. Mondesir, Theird Party Defedan (Not apparent authority. Not a reasonable belief): 50 Cents sometime Dj gave the rights to odenant, owner of world star hiphop to use 50 cents likeness. 50 didn’t know and sued world star. Judge said.. that there is no way worldstar coujld have relied on that his sometimes dj has the power to control his name and likeness.
Undisclosed Principles
• Agent acting without actual authority? Rest. 3d § 2.06 (either of these is sufficient for principal liability):
o 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.
o 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.
Elements:
a. The third party does not know that the person is an agent
b. Either:
ii. The agent is acting within scope of authority; or
iii. The agent is acting outside of the scope of actual authority and
1. The third party detrimentally relies on the agent
2. The principal has notice
3. The principal does not take reasonable steps to notify the third party of the facts;
4. The principal cannot rely on narrowing an agent’s authority to less than what a third party would reasonably believe the agent to have under the circumstances (see Watteau)
• Watteau v. Fenwick (Bovril case)
o Plaintiff, Watteau, sold goods to a pub manager, Humble, under the belief that Humble was actually the pub owner. Fenwick, was the actual owner and Watteau sought to collect from Defendant for the goods purchased by Humble.
o An undisclosed principal can be held liable for the actions of an agent who is acting with an authority that is reasonable for a person in the agent’s position regardless of whether the agent has the actual authority to do so. Thus defendant is liable for damages.
▪ POSSIBLE EXAM Q: The situation is analogous to a partnership wherein one partner is silent but is still liable for actions of the partnership as a whole.
Ratification
• DEFENITION: Ratification 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. This creates an actual authority. Simply the idea that there could be an affirmance of a prior act.. done by another.. as if it was given actual authority..
o No partial ratification
• How it HAPPENS: Ratification can occur by
o (a) manifesting assent that the act shall affect the person’s legal relations; or
o (b) conduct that justifies a reasonable assumption that the person so consents. (Express / implied)
• LIMITATIONS:
o (1) No Material chance in circumstances that would make it inequitable to bind the 3rd party unless the 3rd party choses to be bound.
o (2) 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.
o (3) Implied ratification may occur if principal knew of the contract and didn’t do anything to disaffirm it, i.e. accepted the benefits.
▪ Zions Gate R.v Resort, LLC v. Oliphant (silence could make an implied ratification but need actual facts to show actual knowledge.
• Handyman did work for a company in exchange for a 99 year long lease of an RV plot. Person who signed the lease however was not authorized to do so.
o Was there actual authority? No actual authority. Officer not authorized. Was there apparent authority? Court reasoned that there could be no reasonable belief of apparent authority because the articles of incorp showed that this person did not have the authority to bind the corporation to this lease.
o What about silence on the topic? Its possible to show that someone could ratify with silence but the court wont impute knowledge. Need to show really knowledge.
Estoppel
Definition: A defendant is estopped from disclaiming contractual liability when…
o A third party is justifiably induced to detrimentally rely; and
o Either:
▪ The alleged principal intentionally or carelessly caused such belief; or
▪ The alleged principal was on notice and did not take reasonable steps to notify the third party of the facts
• 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.)
• Not a Contract. Estoppel does not create a binding contract between the parties; it is simply a doctrine that can prevent a principal or purported principal from avoiding an obligation by arguing that no authority existed at the time the agent or actor entered into a contract.
Hoddeson v. Koos Bros: Fake sales rep swindled a family out of their money. Court says via estoppel.. if a place creates and environment where one could reasonably believe they were getting the service of the place, they are liable. Alleged principal cannot deny agency when reasonable surveillance and supervision would have stopped an imposter and a third party detrimentally relied.
Agents Contract Liability
• Fully Disclosed Agency, Within Scope of authority: When the P is fully disclosed and A is acting within the scope of authority, P is liable to the T. A is not liable.
o 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 Unidentifiable Principal: When the P is undisclosed, both the P and A are liable on the contract (unless excluded/otherwise agreed).
o Almost always the same when the P is unidentified.
• Agent Exceeding the Scope of Authority: An agent who enters into a contract on behalf of another impliedly warrants that he or she has the authority to do so. If the agent acted without authority or exceeded the scope of authority and the principal did not ratify, the agent is liable to the third party for breaching the implied warranty of authority
o Exception:
▪ The agent gives notice that no warranty of authority is given; OR
▪ The third party knows that the agent acts without actual authority
• Implied Warranty of Authority: A person who purports to make a contract, representation, or conveyance to or with a third party on behalf of another person, lacking power to bind that person, gives an implied warranty of authority to the third party and is subject to liability to the third party for damages for loss caused by breach of that warranty, including loss of the benefit expected from performance by the principal, unless
▪ (1) the principal or purported principal ratifies the act . . . ; or
▪ (2) the person who purports to make the contract, representation, or conveyance gives notice to the third party that no warranty of authority is given; or
▪ (3) the third party knows that the person who purports to make the contract, representation, or conveyance acts without actual authority.
HYPOS ON AUTHORITY
- Peter owns an apartment building and has hired Alice to manage it. Peter gave Alice the title of General Manager. Peter tells Alice to hire a company to take care of the swimming pool maintenance. Alice does it. Is Peter bound by the contract? Yes. There is actual authority. In order to do x she needed to do y.
- Without express instructions, Alice hires a janitor to clean the building’s common areas. Is Peter bound by the employment contract with the janitor? Yes. Hiering the janitor is reasonable to managing the building.
- Suppose Peter specifically instructed Alice not to hire a janitor, but that it is customary for apartment managers to have the power to hire janitors. Would Peter be bound by the contract? Yes.. this is APPARENT authority.. Silence that was relies on, see ophthalmic, and the reliance was reasonable. See 50 cent.
Tort Liability
• AN AGENTS LIABILITY FOR TORT General Rule: An agent always remains liable for a tort that he or she commits.
o Exception: “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.”
Principles Liability to a 3rd Party for Agents Tort:
Direct Liability when:
o A acts with actual authority to commit tort or P ratifies A’s conduct
o When a principle ratify’s Agent’s conduct.
o P is negligent in selecting, supervising, or otherwise controlling A
▪ If the principal was only negligent in hiring the agent, the principal is liable only for her own negligence in the hiring, not for the contractor’s negligence unless there is a basis for vicarious liability.
o P delegates performance of a duty to use care to protect persons or property and A fails to perform duty (aka “nondelegable duty”)
▪ If a duty is “non-delegable,” it means that the principal remains liable for a failure to fulfill the duty even if he or she had an agent performing the task. For example, landlords have certain non-delegable duties to their tenants and they cannot discharge or transfer liability simply by hiring an agent to fulfill the duties.
o Activity contracted for is inherently dangerous (e.g., demolition, blasting)
Vicarious Liability When:
o A is an employee who commits a tort while acting within the scope of employment [§ 7.07] [“Respondeat superior”] So we ask:
o 1.How do the classifications work (e.g. “employee”)?
o 2.What counts as “within the scope of employment”?
o A commits a tort when acting with apparent authority in dealing with T on or purportedly on behalf of P [§ 7.08] [“Apparent agency”]
Policy:
• Fairness: The principal gets the benefits of control, ergo the principal should have the corresponding responsibility of liability
• Economics: The lowest cost avoider is the principal; the party with control is in the best position/has the best incentive to take necessary precautions
1. VICARIOUS LIABILITY RESPONDANT SUPERIOR
First we must find… was the torfeezer an EMPLOYEE?
How does one become and employee? 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 NOTE: A gratuitous agent may be an employee
Ask two questions:
o Agent or non agent?
o How much control does the principle have? The vicariousness of employment turns on the amount of control that a person has over the gent (and thus the amount of benefit they get).
Employee vs. Non-Employee (rst 7.07(3)) “Factors” to Consider:
b. The extent of the principal’s control over details of the work
c. Whether the agent is engaged in a distinct occupation/business
d. The kind of occupation and whether the work is usually done under the principal’s direction or w/o supervision
e. Skill required in the particular occupation
f. Who supplies the instrumentalities, tools, and place of work for the agent
g. Length of the agent’s employment
h. Method of payment: by time or by job
i. Is the work a part of the principal’s regular business?
j. Do the parties believe they are creating an employment relationship?
k. Whether the principal is in business
O’Connor v. Uber Technologies [contract saying not employee not dispositive]
o Facts: Lawsuit against Uber by uber drivers that they are actually employees of Uver, and are entitled to certain coified rights from the CA labor code. Uber argues the drivers are not its employees but instead are independent contractors.
- Question: is there considerable control over uber drivers by uber to make them employees? This is disputed, thus no summary judgement.
- Holding
o The fact that they signed contract that says they are not employees.. not dispositive.
o the fact that one is performing work and labor for another is prima facie evidence of employment
o The pertinent question is “not how much control a hirer exercises, but how much control the hirer retains the right to exercise.”
o the Supreme Court has also embraced a number of “secondary indicia” that are relevant to the employee/independent contractor determination. Id. These additional factors include:
▪ (a) whether the one performing services is engaged in a distinct occupation or business;
(b) the kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the principal or by a specialist without supervision;
(c) the skill required in the particular occupation;
(d) whether the principal or the worker supplies the instrumentalities, tools, and the place of work for the person doing the work;
(e) the length of time for which the services are to be performed;
(f) the method of payment, whether by the time or by the job;
(g) whether or not the work is a part of the regular business of the principal; and
(h) whether or not the parties believe they are creating the relationship of employer- employee. – THIS IS THE BORELLO TEST……
o Borello also “approvingly cited” five additional factors (some overlapping or closely related to those outlined immediately above) for evaluating a potential employment relationship. These additional factors include:
▪ (1) the alleged employee’s opportunity for profit or loss depending on his managerial skill; (2) the alleged employee’s investment in equipment or materials required for his task, or his employment of helpers;
(3) whether the service rendered requires a special skill; (4) the degree of permanence of the working relationship; and
(5) whether the service rendered is an integral part of the alleged employer’s business.
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THEN we must find if the employee was within the scope of employment?
• 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.
• Consider:
o Was the conduct of the same general nature as, or incidental to, the task the agent was employed to perform?
▪ See Patterson v. Blair
o Did the conduct occur substantially within the authorized time and space limits of employment? (Frolic vs. Detour)
▪ See Clover v. Snowbird and the CLOVER factors.
o Was the conduct motivated at least in part by a purpose to serve the principal?
Clover v. Snowbird Ski Resort – BEST CASE TO SUM UP EMPLOYMENT
o Facts: Zulliger hit a guest and severly injured them while skiing downt he slopes from one of his duties at a restaurant. He worked at the restaurants in the ski slopes.
o Question: Was this in the scope of employment? Enough ? to not get dismissed
o Holding
▪ Factors for finding if someone is in the scope of employment
• First, an employee’s conduct must be of the general kind the employee is employed to perform....NO personal endeavors.
o The court says there is no doubt evidence that he was working to the benefit of snowbird
• Second, the employee’s conduct must occur substantially within the hours and ordinary spatial boundaries of the employment.
o Court sys a reasonable jury could find it was within the scope or that he had resumed employment by going to the work.
• “Third, the employee’s conduct must be motivated at least in part, by the purpose of serving the employer’s interest.”
Summing Up “Within the Scope of Employment” (CLOVER FACTORS)
o 1. Was the conduct of the same general nature as, or incidental to, the task the agent was employed to perform?
o 2. Did the conduct occur substantially within the authorized time and space limits of employment ? (“detour” vs. “frolic”?)
▪ Frolic: a substantial deviation outside the scope. ‘If straying only slightly, this is a detour.
o 3. Was the conduct motivated at least in part by a purpose to serve the principal?
Patterson v. Blair- Intentional tort can still be in the scope of employment
o Facts: Car dealers son cracked a fool trying to recover a GMC truck that was exchanged at the dealership for a car that had money still on the title.
o Question: was there vicarious liability? Yes
o Holding
▪ Blair was furthering the interests of the business, and was not acting only for himself.
2. VICARIOUS LIABILITY- APARENT AUTHORITY
Was there apparent agency? Apparent agency arises when an agent commits a tort while acting purportedly on behalf of the principal. NOTE: Often arises in context of franchises, hospitals.
• Rest. 3d § 7.08: “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.”
Elements:
l. Reasonable Belief: Circumstances exist which lead an injured third party to reasonably believe that an agency or employment relationship exists between the alleged principal and the alleged agent tortfeasor; and
m. Principal’s Action/Inaction: The circumstances exist because of some action or inaction on the part of the principal in creating or failing to dispel that belief.
n. Justifiable Reliance: Some, but not all, courts also require a showing that the third party’s injury arose out of the third party’s justifiable reliance that an agency or employee relationship existed.
Butler v. McDonald’s Corporation
• Facts: Plaintiff is injured in a McDonald’s.
• Rule: Must prove: (1) that the franchisor acted in a manner that would lead a reasonable person to conclude that the operator and/or employees of the franchise restaurant were employees or agents of the defendant; (2) that the plaintiff actually believed the operator and/or employees of the franchise restaurant were agents or servants of the franchisor; and (3) that the plaintiff thereby relied to his detriment upon the care and skill of the allegedly negligent operator and/or employees of the franchise restaurant
• Holding: MSJ denied; dicta discusses apparent agency
Termination of Agency Relationship
OVERVIEW
• General Rule: Both the principal and the agent can terminate the agency relationship at any time and for any reason by communicating to the other that the relationship is at an end.
o Terminology: renunciation” by the agent; “revocation” by the principal
o A renunciation or revocation is effective when the other party has notice of it.
• NOTE: If the parties have a contractual relationship as well as an agency relationship, it is possible that one of the parties could be in breach, but that does not impinge upon each party’s unilateral power to terminate the agency relationship.
• Terminating Actual Authority (Rest. 3d §§ 3.06-3.10, 3.12)
o Agreement of parties:
▪ The contract between principal and agent states when it will end or upon the happening of a specified event.
o By lapse of time:
▪ At end of specified time, or if none, then within a reasonable time period
o Any time by either party after notice:
▪ At common law, presumed “at will” relationship so either party may terminate
▪ Exception: where “power given as security”
• One party gives a loan, other posts collateral
• There is authority to seize collateral
o 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.
o Fulfillment of the purpose of the agency relationship:
▪ i.e., completion of task
o 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 (Rst. 3d Section3.11)
o General Rule: The termination of actual authority does not end any apparent authority held by the agent. Apparent authority ends when it is no longer reasonable for the third party to believe that the agent continues to act with actual authority. The test is whether the third party knows or reasonably should have known of the termination of the agent’s authority
o Doing Agent law.. when one terminated acual authority.. need to also terminate apparent authority..
HYPO: Supermarket fires an employee
• Is actual authority terminated? Yes. There was notice given to agent by principal.
• How can the principal terminate the agent’s apparent authority? Take away manifestations that would go towards reasonable belief (uniform, business cards, keycards, etc.)
HYPO: Supermarket fires a manger responsible for purchases of fish
• If the manager subsequently orders another shipment of fish on the supermarket’s behalf, must the supermarket pay? Yes, if the fish company did not know of the termination
• How can it terminate the manager’s apparent authority? Call the fish company and tell them the manager has been fired.
TOPIC 2: GENERAL PARTNERSHIPS
PARTNERSHIP FORMATION
• DFINITION: A partnership is “[a]n association of two or more persons to carry on as co-owners a business for profit…”
o A general partnership can be formed without any filing with the state.
o The association must be voluntary, but it can be formed inadvertently
o No Partnership Agreement required: under rupa don’t need to draw up a partnership agreement. But if one is made, then those terms control, subject to limitations.
o Capital Contributions not required: Initial capital contributions are not required from partners. NOTE: Any contributed capital belongs to the partnership and can be any property (real, intangible, etc.)
• Partnerships as Joint Venture: A joint venture is a business endeavor undertaken by two or more parties, typically with a limited scope and/or for a limited time. To the extent that the joint venture is an association of two or more persons to carry on as co-owners a business for profit it will be treated as a general partnership unless it is specifically organized in some other business entity form (such as a corporation or LLC).
• Types of Partnerships
▪ Express Partnerships
▪ Implied Partnerships
▪ Partnerships by Estoppel
Characteristics of Partnerships:
• Joint and Several Liability: General partnerships do not have limited liability. Each partner is jointly and severally liable for the debts of the partnership.
• Control and Management: Unless otherwise agreed, each partner has the ability to participate in the control and management of the partnership.
• Shared Profits: Unless otherwise agreed, partners share profits equally and allocate losses in the same proportion.
• Pass Through Taxation: Partnerships have “pass through” taxation (the partnership itself is not taxed on income and instead the profits or losses of the partnership flow through to the partners to include on their personal tax returns.)
Sources of Law:
• model statutes adopted by states = UPA (1914) or RUPA (1997) (harmonized 2013), 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 105(a) and (b) state this; 105(c) tells you which provisions are mandatory and cannot be altered by agreement. Most states use RUPA.
Basic rules on Partnership Formation
• RUPA § 202(a): “[T]he 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.”
o Cant unilaterally make someone else a partner in a partnership. Need the unanimous consent..
• RUPA § 202(b): That’s true unless those persons instead followed the steps necessary to have it become a limited partnership, LLC, LLP, LLLP, or corporation.
• RUPA § 202(c): Some rules in determining whether a partnership is formed.
o 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.
o 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.
• NOTE: Why the distinction between gross profits and profits? Sharing profits is more indicative of co-ownership. See General Automotive v. Singer (employee/agent got a salary + 3% commission; this is sharing in gross returns)
o 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:
▪ Of a debt by installments or otherwise;
▪ For services as an independent contractor or of wages or other compensation to an employee;
▪ Of rent;
▪ Of an annuity or other retirement or health benefit to a beneficiary, representative, or designee of a deceased or retired partner;
▪ 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
▪ For the sale of the goodwill of a business or other property by installments or otherwise.
Express Partnership Formation Rules per RUPS 105: A partnership agreement may not…
1. Unreasonably restrict a partner’s right of access to partnership books and records;
2. Alter or eliminate the duty of loyalty, although it is permissible to make specific exceptions or carveouts provided they are not manifestly unreasonable;
3. Alter or eliminate the duty of care, although it is possible to make alterations provided they are not manifestly unreasonable and provided they do not authorize conduct involving bad faith, willful or intentional misconduct, or knowing violation of the law;
4. Eliminate the contractual obligation of good faith and fair dealing (but the partnership agreement may prescribe standards, if not manifestly unreasonable, by which performance of the obligation is measured);
5. Vary the power of a partner to dissociate;
6. Vary the grounds for a court to expel a partner under specific circumstances;
7. Vary the causes of dissolution upon a partner or transferee’s application to a court under specific circumstances;
8. Vary the requirement to wind up the partnership business in certain circumstances; or
9. Restrict the right of third parties under RUPA
Implied Partnership Formation.
• How does an alleging party show? The burden is on the party alleging the partnership
• Consider the RUPA § 202(c) Factors
1. JOINT PROPERTY ≠ PARTNERSHIP
2. SHARING GROSS RETURNS ≠ PARTNERSHIP
3. SHARING PROFITS = PARTNERSHIP
o …UNLESS PROFITS ARE IN PAYMENT OF DEBT, SERVICES, WAGES, RENT, ANNUITY, INTEREST ON LOAN, SALE OF GOODWILL, ETC.
• Consider the Court-Developed Factors
1. Intention of parties
2. Profit sharing
3. Sharing of losses (risk)
4. Management (control)
5. Ownership of property (control)
6. Rights of parties on termination/dissolution
7. Conduct/holding out to third parties
HYPO: Alex and Beverly, wedding planners, agree to pool their gross receipts in a single account, pay all expenses out of the joint account, and ten split the profits. In the absence of evidence to the contrary, is this a partnership? Yes.
• What if Beverly had originally loaned money to Alex for him to use in starting his business and Beverly argues that the sharing of profits was Alex’s way of repaying her? Not a partnership. Although there is prima facie evidence of partnership, an exception applies (202(c)(3)(i): share of profits was received in payment of a debt)
Fenwick v. unemployment Corp- Wages not sharing profits.
• Facts: Fenwick gave a split of profits that his shop made to his employee.
• Issue: Was this arrangement a partnership? No.
• Analysis:
|Factors |Partnership |Employment |
|Intention of Parties |Express/Writing | |
|Profit Sharing |Yes (RUPA § 202(c)(3)) |But might be wages (RUPA § 202(c)(3)(ii)) |
|Sharing of Losses | |No – Fenwick has all the risk; Chesire did not invest $ |
|Management | |No – Fenwick has all the control/managerial power |
|Ownership of Property | |Only Fenwick had ownership rights |
|Rights of Parties on | |Looked like simple employment termination, 10 days’ notice |
|Termination/Dissolution | | |
|Conduct/Holding Out to Third Parties| |With limited exception, not held out as partners |
| | |= Court holds employment |
The Big Takeaways so far re: Formation/ definition
• Have “two or more persons” associated together “to carry on as co-owners a business for profit”?
• RUPA § 202(c) rules.
• And look to court-developed factors
Martin v. Peyton- Does nto satify partnership factors.
• Facts: Respondents, Respondents agreed to loan Hall $2.5 million in securities for Hall to secure $2 million in loans. In return, Respondents received Hall’s more speculative collateral and would receive a percentage of Hall’s profits. Respondents acquired the ability to review Hall’s books and veto certain investments.
• Issue: Is this a partnership? No.
• Held: Although Respondents ensured that they had some control over the operations of Hall’s business, the controls they bargained for were to ensure that their investment was secure. Hall still was able to control the day-to-day affairs, and Respondents never had control to initiate their own ideas.
|Factors |Partnership |Employment |
|Intention of Parties | |Express/Writing |
|Profit Sharing |Yes (RUPA § 202(c)(3)) |But might be interest on loan (RUPA § 202(c)(3)(v)) |
|Sharing of Losses | |No- fixed amount to be returned by deadline |
|Management |Some evidence of control |But is it consistent with “ordinary caution” of a worried lender? |
| |by PPF | |
|Ownership of Property | |No – only security for loan |
|Rights of Parties on Termination/Dissolution | |Loan due in full after 2 year term? |
|Conduct/Holding Out to Third Parties | |Not held out as partners |
| | |= Court holds lenders |
Partnerships by Estoppel (RUPA § 308)
• General Rule: Under the concept of partnership by estoppel, third-parties can sometimes hold non-partners liable as though they were partners
• ELEMENTS:
o 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
o The third party relied on this representation in entering into a transaction with the actual or purported partnership
▪ I.e. There is a change in position with consequent injury in reliance on the representation
HYPO: If person got a bank loan using someone else’s good name for the loan, and the persons name who was being used, he would be treated as a partner (via estoppel) because his conduct implied he was a partner and it allows the bank, who relied on his representation to recover.
Young v. Jones- No representation and no reliance.
• Facts: Plaintiffs deposited $500k in a South Carolina Bank, who forwarded it to SAFIG. Plaintiffs assert they made the deposit on the basis of a PW-Bahamas audit letter (which was actually fraudulent). The plaintiffs’ money and its investment potential has been lost to the plaintiffs and it is for these losses that the plaintiffs seek to recover damages. Plaintiffs assert that PW–Bahamas and PW–US [the Price Waterhouse partnership in the United States] operate as a partnership, i.e., constitute an association of persons to carry on, as owners, business for profit. In the alternative, plaintiffs contend that if the two associations are not actually operating as partners they are operating as partners by estoppel.
• Question: Is there partnership via estoppel between PW US and PW Bahamas. No.
• Holding: General rule. Not liable for partners. This exception to this is partnership by estoppel. There was no partnership with PWS US and Bahamas. Further no estoppel because there was no representation by PW-US and thus no reliance because there was no representation.
Chavers v. Epsco (payroll/ HR provider)– ex of a slam dunk estoppel case..
- Facts: Family run business.. called themselves partners. Had a lot of insignia of partnership. Bank extended credit. Suing partners to get it. Sons claiming not aprtners only dad. Had a card that said partner.
- Question: Is there partnership by estoppel?
- Holding: Yes. TC said there was based on representations and reliance. There was a fax cover sheet that showed the two brothers as partners. The credit app shoes the same thing with Epsco. Checks were written out by the sons. Business cards read owners.
Wrap up of Partnership formation:
• Definition and statutory considerations: RUPA § 202
• Case law interpreting and applying, with factors:
o Fenwick (partner vs. employee example)
o Martin (partner vs. lender example)
• Partnership by Estoppel (purported partnerships for purposes of third party liability)
o Young
o Chavers
The Fiduciary Duty of Partners
• Overview
o Partners are fiduciaries of each other and the partnership
o A partner owes to the partnership and the other partners the duties of care, loyalty, and good faith (RUPA 409)
▪ Duty of Care: The duty of care of a partner is to refrain from engaging in grossly negligent or reckless conduct, willful or intentional misconduct, or a knowing violation of law.
▪ Duty of Loyalty: The fiduciary duty of loyalty of a partner includes the duties…
• To account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner
o In the conduct or winding up of the partnership’s business;
o From a use by the partner of the partnership’s property, or
o From the appropriation of a partnership opportunity.
• To refrain from dealing with the partnership …as or on behalf of a person having an interest adverse to the partnership; and
• To refrain from competing with the partnership
▪ Duty of Good Faith: A partner shall discharge the duties and obligations under this [act] or under the partnership agreement and exercise any rights consistently with the contractual obligation of good faith and fair dealing.
• And “(e) A partner does not violate a duty or obligation under this [act] or under the partnership agreement solely because the partner’s conduct furthers the partner’s own interest.
• (f) All the partners may authorize or ratify, after full disclosure of all material facts, a specific act or transaction by a partner that otherwise would violate the duty of loyalty.
• (g) It is a defense to a claim under subsection (b)(2) and any comparable claim in equity or at common law that the transaction was fair to the partnership. . .
• Ratifying/Curing a Breach
o All partners may authorize or ratify, after full disclosure of all material facts, a specific act or transaction by a partner that otherwise would violate the duty of loyalty.
o It is a defense to a claim…that the transaction was fair to the partnership
• Information Disclosure
o The partnership shall furnish to each partner… (RUPA § 408(c))
▪ Without demand, any information concerning the partnership’s business, financial condition, and other circumstances which the partnership knows and is material to the proper exercise of the partner’s rights and duties under the partnership agreement or this [act]
▪ On demand, any other information concerning the partnership’s business, financial condition, and other circumstances, except to the extent the demand or the information demanded is unreasonable or otherwise improper under the circumstances.
RUPA section 105: Nonwaivable Provisions
• “(c) The partnership agreement may not:…”
o Unreasonably restrict a partner’s right of access to partnership books and records;
o Alter or eliminate the duty of loyalty, although it is permissible to make specific exceptions or carveouts provided they are not manifestly unreasonable;
o Alter or eliminate the duty of care, although it is possible to make alterations provided they are not manifestly unreasonable and provided they do not authorize conduct involving bad faith, willful or intentional misconduct, or knowing violation of the law;
o Eliminate the contractual obligation of good faith and fair dealing (but the partnership agreement may prescribe standards, if not manifestly unreasonable, by which performance of the obligation is measured);
o Vary the power of a partner to dissociate; …
o Restrict the right of third parties under RUPA.
Meinhard v. Salmon: didn’t disclose.. and was an opt that belonged to the joint venture.
• Facts: Money partner and labor partner went n on a real estate JV. Before the end of the term the labor partner took proceeds he had earned from the JV to lease another property. Money partner sues.
• Question: Is this lease part of the JV? Is there a fiduciary?
• Holding: Salmon breached his fiduciary duty by keeping his transaction from Meinhard, which prevented Meinhard from enjoying an opportunity that arose out of their joint venture. A co-adventurer is required to inform another co-adventurer of a business opportunity that occurs as a result of participation in a joint venture
▪ As sharers in a joint venture, co-adventurers owe each other a high level of fiduciary duty. A co-adventure who manages a joint venture’s enterprise has the strongest fiduciary duty to other members of the joint venture.
▪ The Midpoint Lease was an extension of the subject matter of the Bristol Lease, in which Meinhard had a substantial investment. Salmon was given the opportunity to enter into the Midpoint Lease because he managed the Bristol Hotel property. Because Salmon’s opportunity arose as a result of his status as the managing co-adventurer, he had a duty to tell Meinhard about it.
Meehan v. Shaughnessy
• Facts: Meehan and Boyle were partners at a law firm. They created a competing firm and left their current firm. They are suing for lost wages and money they are owed from when they left. They took numerous steps to secretively lining up clients to leave and took success in confusion created by secretly lining up their exit.
• Question: Breach of fiduciary? Yes.
• Holding
o Partners owe each other a fiduciary duty to act with loyalty and in good faith to each other. Consequently, partners may not use their status as partners to purely benefit themselves, particularly if their actions harm the other partners.
o Meehan and Boyle took unfair advantage of the other Parker Coulter partners by acting in secret to solicit clients, falsely denying their plans to the other partners, and delaying the release of the list of clients they planned to take with them until after they had won their business.
o Pertinent ethical standards require that when attorneys planning to leave a firm solicit clients, they must state that the clients have a choice of staying with the firm or transferring their business to the departing attorneys’ new firm. Boyle did not put that information in his solicitation letters
o WARNING: Meehan is not the last word on client contact, taking client lists, and soliciting other employees. Look to relevant state law regarding fiduciary duties as well as ethics rules. Many firms explicitly ban such behavior in partnership agreements and courts will enforce the terms of those contracts.
Rights of Partners in Management; Partnership Liability
RUPA 401(h) Each partner has equal rights in the management and conduct of the partnership’s business. RUPA 401 (h)
a. Default Rule: 1 partner, 1 vote (a “per capita basis”).
i. 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.
b. The default rule can be altered by agreement.
i. EXAMPLE: A contributes 70% of the partnership capital, B contributes 20% of the partnership capital, and C contributes 10%. The partners agree that A gets 7 votes, B gets 2 votes, and C gets 1 vote, in accordance with their economic contributions.
§ 401(k): “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.”
Partner Agent of a Partnership (Defailt Partnership’s Liability in Contract: § 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 did not have 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.”
• Hypo: A, B, and C form a partnership to run a pet hospital. All agree between themselves 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 for the partnership.
• Could the partnership be liable on an advertising contract that A entered into on behalf of the partnership?
Statement of Partnership Authority: § 303: Allows a partnership to centrally file (e.g. 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.
• Third parties are only deemed to know of a limitation of authority in such a filed statement if it concerns the limitation of authority to transfer real property.
Partnership Liable for Partner’s Actionable Conduct
• § 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.”
• § 306: “(a) 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.
o (b) 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.
o (c) A debt, obligation, or other liability of a partnership incurred while the partnership is a limited liability partnership (LLP) is solely the debt, obligation, or other liability of the partnership. . .”
• Partnership Decision making (RUPA § 401(k)) - General Rule: Unless otherwise agreed…
a. Ordinary course of business = majority vote
b. Limit on actual authority of a partner in ordinary course = majority vote
c. Outside ordinary course of business = affirmative vote or consent of all partners
d. Amendment to partnership agreement = affirmative vote or consent of all partners
• This is a default rule that can be altered by agreement (RUPA § 105(a))
Boiled Down: Partnership Liability
• Partner’s Authority to Bind the Partnership in Contract (RUPA §301)
a. Overview
i. Each partner is an agent of the partnership for the purpose of its business.
ii. A partnership can be bound to a contract by a partner’s actual or apparent authority.
1. NOTE: 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 (RUPA § 306)
b. Analysis
i. Was there actual authority?
1. By default, partners have actual authority within the ordinary course of business.
2. The partnership agreement can limit the authority of a partner
3. RUPA allows a partnership to centrally file, such as with the secretary of state (and, for real property transfers, with the county recorder), 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.
a. Third parties are only deemed to know of the limitation if it concerns the authority to transfer real property.
4. The partnership can also limit the authority of a partner by an agreement of a majority of partners
a. NOTE: 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.
b. See National Biscuit
ii. Was there apparent authority?
1. Partners have apparent authority within the ordinary course of business, unless the partner had no authority to act for the partnership in a particular matter and the third party knew or had received a notification that the partner lacked authority
National Biscuit v. Stroud [ Need majority to bind partnership in decisions. Otherwise both partners are liable]
• Facts: General partnership with 2 partners to run a grocery. One partner keeps buying stuff from Nabisco, even after the Defedant partner says to Nabisco I AM NOT LIABLE FOR THESE ORDERS. Grocery shuts down. Nabisco sues other parter to get the money. Partner says I’m not liable!
• Question: Is the partner liable? Yes.
• Holding: Partners are jointly and severally liable for the actions of the partnership. Freeman’s conduct in allowing the deliveries was within the scope of the business and he has a right to make these decisions unless a majority of the partners vote to deny him of these rights. Since Stroud is only one half of the partnership, and not a majority, he is unable to prevent Freeman from exercising his rights.
o 2.Why wasn’t Stroud’s notification to National Biscuit enough for him to restrict Freeman’s ability to bind the partnership? He wasn’t a majority partner.
o 3.How could the parties have averted or mitigated the problem that gave rise to the litigation? Given a majority to a person. Or ended the partnership before.
Summers v. Dooley
• Facts: Plaintiff and Defendant agreed to operate a trash-collecting business. They decided to perform the work themselves, and if either was unable to perform then that partner was responsible for paying a third party to work on his behalf. Plaintiff was unable to perform his duties and suggested that the business hire an employee. Defendant objected but Plaintiff hired another person anyway, personally costing Plaintiff $11,000. Plaintiff wanted to be reimbursed for half of the costs.
• Issue. Is the partnership responsible for the cost of the new employee?
• Holding: The Plaintiff should not be compensated by the partnership for the cost of the additional employee. The additional employee was brought on for the personal benefit of Plaintiff and not the partnership. Defendant repeatedly rejected the hiring. A decision to change the status quo would also require a majority approval, and Plaintiff’s one vote did not constitute a majority.
o 1.Can you reconcile Summers v. Dooley with National Biscuit v. Stroud? Why was the contract binding on the partnership in National Biscuit, but not binding on the partnership in Summers? Because partnership agreement terms of liability were agreed on in the altter and not the former.
o 2.In a “deadlock” situation where there is one partner “for” a proposed action and one partner “against,” how do you know which partner wins?
o Default rules allow every partner to bind in ordinary course
o Default rule require a majority vote to be resolved..
Partnership’s Tort Liability (RUPA § 305(a))
• General Rule: 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.
a. The “ordinary course of business of the partnership” = 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).
b. 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).
Financial Aspects of a Partnership (Sharing of Profits and Losses; Partnership Property; Related Topics)
o Partnership Property
▪ Partnership property (Covered in RUPA 203+204) refers to everything that a partnership owns—including capital and property that is subsequently in partnership transactions and operations.
▪ Partnership capital is the property or money contributed by each partner for the partnerships business.
▪ What does it mean to be part of a partnership property wise? A partner has an interest in partnership property but no direct right.
▪ A partner may use or possess partnership property only on behalf of the partnership.
• NOTE: It might matter that property belongs to the partnership because it would be a partnership asset that could be used to meet a partnership debt (before a third party would look to the partners for joint and several liability).
▪ Property acquired by a partnership is the property of the partnership and not of the partners individually. Partnership property includes property that is either:
• Acquired in the name of the partnership (“titled” in the partnership name)
• Acquired by one or more partners with a document transferring title that indicates the partner was acting in his capacity as a partner or indicates the existence of a partnership.
▪ Presumed to the Partnership. Property purchased with partnership funds is presumed to be partnership property.
▪ Property only used for Partnership. RUPA § 401(i): “A partner may use or possess partnership property only on behalf of the partnership.”
▪ Presumed to the Partner. Property acquired in the name of one or more of the partners, without an indication of the person’s capacity as a partner or the existence of a partnership, and without use of partnership assets, is presumed to be separate property, even if used for partnership purposes.
Wyatt v. Byrd [MAJORITY RULE on partnership assets belonging to the partnership]
• Facts: Dating couple had a partnership that dissolved. One of the partners ought a house with money from the partnership bank account, even though they put personal funds in it as well. Other partner saught to get a right to the property that was purchased.
• Question: Is the house the property of the partnership? Yes.
• Holding:
o Step 1 Was there a partnership? Yes. The burden of proof rests on the party seeking to establish the existence of a partnership. Court says laboring together and sharing money implies that they intended to share the profits and losses together.. thus there was a partnership.
o Step 2 Property as Partnership/ JV asset? Look to the state statute. Tenessee code says: Property transferred to or otherwise acquired by a partnership is property of the partnership and not of the partners individually.” Even if the property is not acquired in the name of the partnership or in the name of a partner in the capacity as a partner.
Transferring Property (Transferrable Interest)
▪ A partner has a transferable interest in the partnership.
o A transferable interest is “the right, as initially owned by a person in the person’s capacity as a partner, to receive distributions from a partnership, whether or not the person remains a partner or continues to own any part of the right. The term applies to any fraction of the interest, by whomever owned.” (RUPA § 502)
o No Management Interest. The partners stake in property can be transferred no strings attached. But the transfer has no right to manage the partnership.
o When one does give their interest in the transfer.. they are still a partner and have all the management responsibility.. just don’t get the distribution. ((RUPA 102)(33)
Effect of Transfer (RUPA § 503)
• A transfer does not by itself cause dissociation or dissolution
• A transfer does not entitle the transferee to participate in the management or conduct of the partnership
• A transferee has the right to
a. Receive distributions to which the transferor would be otherwise entitled
b. Seek a judicial determination that it is equitable to wind up the partnership business
HYPO: Lawyer 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, §202
• If 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, §501
a. RUPA § 501: “A partner is not a co owner of partnership property and has no interest in partnership property which can be transferred, either voluntarily or involuntarily.”
• Does Jean-Paul have any right he can assign to Maria? – Yes, §502
a. 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.”
• New scenario: What if a personal creditor of Jean-Paul’s wants to go after his interest? – Yes, §504
a. RUPA § 504: Partner’s transferable interest subject to charging order.
Charging Orders: RUPA § 504: Partner’s transferable interest subject to charging order. Simply a lien by CREDITORS. Applies against the transferable interest for the unsatisfied amount of the judgment. The partnership will pay any distribution that would otherwise be paid to the judgment debtor.
Reimbursements: RUPA § 401(b): “A partnership shall reimburse a partner for any payment made by the partner in the course of the partner’s activities on behalf of the partnership…”
Idemnification: RUPA § 401(c): “A partnership shall indemnify and hold harmless a person with respect to any claim or demand against the person and any debt, obligation, or other liability incurred by the person by reason of the person’s former or present capacity as a partner, if the claim, demand, debt, obligation does not arise from the person’s breach [of this section, § 407 on improper distributions, or § 409 on standards of conduct for partners].”
Loans:
• RUPA § 401(e): A payment or advance made by a partner which gives rise to a partnership obligation under subsection (c) or (d) constitutes a loan to the partnership which accrues interest from the date of the payment or advance.
• RUPA § 401(g): A partner can make a loan to the partnership, “which accrues interest from the date of the payment or advance.”
Sharing in Partnership Profit and Losses
• Partnership Capital Account: Each partner has an account that is a running balance reflecting: their contributions (money + the value of any other property); their share of profits; any distributions; and their share of losses
o No Capital required. As a matter of default, initial capital contributions are not required from partners. Some or all partners may contribute only services.
o Vocab: a “service partnership” or “K-and-L partnership” = where one partner provides all the capital and another provides all the labor.
o The contributed capital itself belongs to the partnership and can be any property (real, intangible, etc.). Sweat doesn’t count as a credit.
o When dissolving a partnership, all debts must be paid before a distribution can be taken. If there is not enough money in the partnership to be paid, each partner is jointly and severally liable.
o Boiled down the credit account tracks a partners: (i) their contributions (money plus the value of any other property), (ii) their share of profits, (iii) any distributions (taking a “draw”), and (iv) their share of losses.
• Compensation for Services--Default Rule: A partner is not compensated for services
• Distribution of Profits and Losses
o Default Rule: 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(a)]
▪ Equal share of profits and losses in proportion
▪ Does it make a difference if the partners contributed unequal amounts of capital or labor? No.
▪ Can a general partnership be formed if there is no agreement about how losses will be shared? Yes.
▪ If A and B agree to split profits 60/40 but say nothing about losses, losses will be split 60/40.
o RUPA is silent on when profits are distributed.
▪ Comment to § 401: Absent an agreement, the interim distribution of profits is a matter arising in the ordinary course of business to be decided by majority vote of the partners
Contribution HYPO: Hiro agrees to contribute to the Dos Commas Partnership a parcel of land valued at $500k, in return for a 20% share of the partnership profits. During the next few years, rental from the land accounts for 25% of the partnership’s profits, and the land increases in value to $1.5M. The benefits from the land, and increase in value, belong to the partnership, not Hiro, whose remuneration as partner is the 20% share of profits.
▪ In addition to his respective right to share in distributions, if the partnership were to dissolve, Hiro would have a right to a return of the $500k (if it had not previously been returned not including distributions), no matter what the modern value is.
Distributions: Majority of the partners decides on distributions. Comment to § 401:
Settlement of Accounts and Contributions in Winding Up
• Winding up is the period before termination of the partnership, when the partnership concludes its business, sells its assets, pays creditors, and settles its partnership accounts.
• Termination occurs once the winding up is done.
Order of Settlement of Accounts and Contributions (RUPA § 806)
• Take partnership assets and pay out whatever is obligated to creditors
• Surplus is divided among partners in accordance with right to distributions
• A partner must contribute to the partnership an amount equal to an excess of the charges over the credits in the partner’s accounts
• If a partner fails to contribute the full amount required, all of the other partners must contribute (in proportion to the share of losses) the additional amount necessary to satisfy the partnership obligations for which they are personally liable
Hypo: Carlos and Lily form a partnership to operate a goat cheese business, agreeing to share profits equally. Carlos contributes a small farm worth $50k. Three years later the partnership comes to an end. Lily’s capital contribution had already been returned by the partnership. By selling all of its assets other than the farm, the partnership has enough cash to pay off its debts to creditors—exactly to the dollar. During the partnership land values increased and so the partnership is now able to sell the farm for $100k. How will the proceeds of the sale of the farm be handled? Do they go entirely to Carlos or are they divided in some other way? Carlos gets his 50k back.. then 25 to each after that.
Hypo: A, B, and C are in a partnership and it goes out of business. They have not contracted around the default RUPA rules. A creditor of the partnership subsequently collects $21k from C on a debt owed by the partnership (while each A, B, and C were a part of it). The partnership has no funds to reimburse C. Can C collect money from A and B, and if so, how much? Yes 7k from each other partner.
Illustration of MAJORITY RUPA: Celia and Larry form a partnership to run a catering service. They do not make any agreements changing the default RUPA rules. Celia provides $250k in start-up money and does not work in the business. Larry works full-time in the business, but contributes no capital. The partnership ends after a year, paying off all creditors but with nothing left over. The partnership has suffered at $250k loss (per Celia’s $250k capital contribution). For his year of work, Larry received nothing. Per the RUPA rules, Larry must pay $125k to the partnership, which will then distribute that amount to Celia. Both Larry and Celia will then have each lost $125k.
Then we have the minority position Minority position…
Kovacik v. Reed – opposite of RUPA.. Minority Rule.
▪ Facts: Kovacik and Reed went in on a JV to kitchen remodeling work. K asked to be his super intendant on the venture. K has 10k to invest in the project and if R worked with him theyd split profits 50/50. The venture was unprofitable. K then initiated this to recover the losses..
▪ Question: is the guy allowed to… recoup his 10k? NO.
▪ Holding: A service partner does not have to share in capital contribution loss. Rationale: The service partner is the less sophisticated partner (generally) and may not have known that this was the consequence of their partnership.
RUPA Response to Kovacik: Default rules apply even if a partner contributed no capital
Partnership Dissociation and Dissolution
• Partner dissociation, a situation where a partner leaves the partnership. Doesn’t necessarily mean winding up.
o NOTE: A person’s dissociation does not itself discharge the person from any debt, obligation, or other liability to the partnership or the other partners which the person incurred while a partner (RUPA § 603(c))
• Dissolution: Dissolution causes the partnership to wind up absent an agreement to continue (buy-out and continuation agreements) or by unanimous vote or consent (including any dissociating partner other than a wrongfully dissolving partner)
• Winding Up: Involves shutting down the business by selling off the assets, paying the partnership liabilities, and settling partner accounts. The authority of partners to act on behalf of the partnership is terminated except in connection with winding up partnership business
o Once winding up is finished, the partnership is terminated. No filing necessary.
Dissociation is triggered by the events in RUPA § 601-- Effect:
• Right to management ceases
• Duties of care and loyalty generally also terminated, except for matters arising before dissociation
• Purchase of dissociated partner’s interest
• Indemnification of dissociated partner
• Dissociated partner’s power to bind partnership
• Dissociated partner’s liability to other parties
Effect of Dissociation: RUPA 603 (switching provision):
• Depending on the act of dissociation, 1 of 2 consequences will occur:
o If the event is listed in RUPA § 801, then dissolution is triggered.
o If the event is not listed in RUPA § 801, and provided the dissociation was NOT WRONGFUL, then a buyout will occur pursuant to RUPA § 701 and the partnership business continues.
So first ask: Is the event in 801? If not then ask Was it wrongful? If the dissociation was not wrongful, a buyout will occur pursuant to RUPA § 701 and the partnership business continues
• The dissociated partner is entitled to a buyout at the buyout price
• Buyout Price: The amount that would have been distributable to the person under Section 806(b) if, on the date of dissociation, the assets of the partnership were sold and the partnership were wound up, with the sale price equal to the greater of: (1) the liquidation value; or (2) the value based on a sale of the entire business as a going concern without the person.
If the dissociation was wrongful, damages for that action are deducted from the buyout amount and the payment may be deferred
• A partner will be deemed to have wrongfully dissociated if:
a. The dissociation is in breach of an express term of the partnership; or
b. The 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
• NOTE: If a partner wrongfully dissociate…
a. Partner is liable to the partnership for any damages caused by the dissociation
b. Partner is not entitled to payment of the buyout price until the expiration of the term
i. Exception: The person establishes to a court that earlier payment will not cause undue hardship to the business of the partnership
Consequences of dissociation:
o Right to management ceases; duties of care and loyalty generally also terminated, except for matters arising before dissociation. RUPA § 603(b).
o Purchase of dissociated partner’s interest. RUPA § 701.
o Indemnification of dissociated partner. RUPA § 701(d).
o Dissociated partner’s power to bind partnership. RUPA §§ 702, 704.
o Dissociated partner’s liability to other parties. RUPA § 703.
Events Triggering Dissociation (RUPA § 601)
1. The partnership knows or has notice of the person’s express will to withdraw as a partner
a. But, if the person has specified a withdrawal date later than the date the partnership knew or had notice, on that later date;
2. An event stated in the partnership agreement as causing the person’s dissociation occurs;
3. The person is expelled as a partner pursuant to the partnership agreement;
4. The person is expelled as a partner by the affirmative vote or consent of all the other partners if:
a. It is unlawful to carry on the partnership business with the person as a partner;
b. There has been a transfer of all of the person’s transferable interest in the partnership, other than:
i. A transfer for security purposes; or
ii. A charging order in effect under Section 504 which has not been foreclosed;
c. The person is an entity and:
i. The partnership notifies the person that it will be expelled as a partner because the person has filed a statement of dissolution or the equivalent, the person has been administratively dissolved, the person’s charter or the equivalent has been revoked, or the person’s right to conduct business has been suspended by the person’s jurisdiction of formation; and
ii. Not later than 90 days after the notification, the statement of dissolution or the equivalent has not been withdrawn, rescinded, or revoked, or the person’s charter or the equivalent or right to conduct business has not been reinstated; or
d. The person is an unincorporated entity that has been dissolved and whose activities and affairs are being wound up;
5. On application by the partnership or another partner, the person is expelled as a partner by judicial order because the person:
a. Has engaged or is engaging in wrongful conduct that has affected adversely and materially, or will affect adversely and materially, the partnership’s business;
b. Has committed willfully or persistently, or is committing willfully or persistently, a material breach of the partnership agreement or a duty or obligation under Section 409; or
c. Has engaged or is engaging in conduct relating to the partnership’s business which makes it not reasonably practicable to carry on the business with the person as a partner;
6. (DEBT) The person:
a. Becomes a debtor in bankruptcy;
b. Signs an assignment for the benefit of creditors; or
c. Seeks, consents to, or acquiesces in the appointment of a trustee, receiver, or liquidator of the person or of all or substantially all the person’s property;
7. (DEAD/INCOMPETENT) In the case of an individual: (A) the individual dies; (B) a guardian or general conservator for the individual is appointed; or (C) a court orders that the individual has otherwise become incapable of performing the individual’s duties as a partner under this [act] or the partnership agreement;
8. (TRUST GONE) In the case of a person that is a testamentary or inter vivos trust or is acting as a partner by virtue of being a trustee of such a trust, the trust’s entire transferable interest in the partnership is distributed;
9. (ESTATE GONE) In the case of a person that is an estate or is acting as a partner by virtue of being a personal representative of an estate, the estate’s entire transferable interest in the partnership is distributed;
10. (ENTITY PARTNER IS GONE) In the case of a person that is not an individual, the existence of the person terminates;
11. (MERGER) The partnership participates in a merger under [Article] 11 and: (A) the partnership is not the surviving entity; or (B) otherwise as a result of the merger, the person ceases to be a partner;
12. The partnership participates in an interest exchange under [Article] 11 and, as a result of the interest exchange, the person ceases to be a partner;
13. The partnership participates in a conversion under [Article] 11;
14. The partnership participates in a domestication under [Article] 11 and, as a result of the domestication, the person ceases to be a partner; or
15. The partnership dissolves and completes winding up.
Events Triggering Dissolution and Winding Up (RUPA § 801)
1. The partnership knows or has notice of a person’s express will to withdraw as a partner
2. In a partnership for a definite term or particular undertaking:
a. Within 90 days after a person’s dissociation by death or otherwise under Section 601(6) through (10) or wrongful dissociation under Section 602(b), the affirmative vote or consent of at least half of the remaining partners to wind up the partnership business, for which purpose a person’s rightful dissociation pursuant to Section 602(b)(2)(A) constitutes that partner’s consent to wind up the partnership business;
b. The affirmative vote or consent of all the partners to wind up the partnership business; or
c. The expiration of the term or the completion of the undertaking;
3. On an event or circumstance that the partnership agreement states causes dissolution;
4. On application by a partner, the entry by [the appropriate court] of an order dissolving the partnership on the grounds that:
d. The conduct of all or substantially all the partnership’s business is unlawful;
e. The economic purpose of the partnership is likely to be unreasonably frustrated;
f. Another partner has engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business in partnership with that partner; or it is otherwise not reasonably practicable to carry on the partnership business in conformity with the partnership agreement;
i. Most common
5. On application by a transferee, the entry by [the appropriate court] of an order dissolving the partnership on the ground that it is equitable to wind up the partnership business: (A) after the expiration of the term or completion of the undertaking, if the partnership was for a definite term or particular undertaking at the time of the transfer or entry of the charging order that gave rise to the transfer; or (B) at any time, if the partnership was a partnership at will at the time of the transfer or entry of the charging order that gave rise to the transfer; or (6) the passage of 90 consecutive days during which the partnership does not have at least two partners.
Partners’ Liability and Power After Dissociation/Dissolution
6. Liability of Dissociated Partner (RUPA § 703)
a. A person dissociated as a partner is not liable for a partnership obligation incurred after dissociation.
b. A person that is dissociated as a partner is liable on a transaction entered into by the partnership after the dissociation only if:
i. A partner would be liable on the transaction; and
ii. At the time the other party enters into the transaction:
1. Less than two years has passed since the dissociation; and
2. The other party does not have knowledge or notice of the dissociation and reasonably believes that the person is a partner.
c. By agreement with a creditor of a partnership and the partnership, a person dissociated as a partner may be released from liability for a debt, obligation, or other liability of the partnership.
d. A person dissociated as a partner is released from liability for a debt, obligation, or other liability of the partnership if the partnership’s creditor, with knowledge or notice of the person’s dissociation but without the person’s consent, agrees to a material alteration in the nature or time of payment of the debt, obligation, or other liability.
7. Former Partner’s Power to Bind Partnership After Dissolution (RUPA § 804)
a. A person dissociated as a partner binds a partnership through an act occurring after dissolution if:
i. At the time the other party enters into the transaction:
1. Less than two years has passed since the dissociation; and
2. The other party does not know or have notice of the dissociation and reasonably believes that the person is a partner; and
ii. The act:
3. Is appropriate for winding up the partnership’s business; or
4. Would have bound the partnership under Section 301 before dissolution and at the time the other party enters into the transaction the other party does not know or have notice of the dissolution.
8. Liability of Dissociated Partner After Dissolution (RUPA § 805)
a. If a partner having knowledge of the dissolution causes a partnership to incur an obligation under Section 804(a) by an act that is not appropriate for winding up the partnership business, the partner is liable:
i. To the partnership for any damage caused to the partnership arising from the obligation; and
ii. If another partner or person dissociated as a partner is liable for the obligation, to that other partner or person for any damage caused to that other partner or person arising from the liability.
b. Except as otherwise provided in subsection (c), if a person dissociated as a partner causes a partnership to incur an obligation under Section 804(b), the person is liable:
i. To the partnership for any damage caused to the partnership arising from the obligation; and
ii. If a partner or another person dissociated as a partner is liable for the obligation, to the partner or other person for any damage caused to the partner or other person arising from the obligation.
c. A person dissociated as a partner is not liable under subsection (b) if:
i. Section 802(c) permits the person to participate in winding up; and
ii. The act that causes the partnership to be bound under Section 804(b) is appropriate for winding up the partnership’s business.
9. Rescinding Dissolution (RUPA § 803)
10. McCormick v. Brevig (JUDICIAL DISSOLUTION 801)
▪ Facts: Two siblings inherited a rank from the parents. Created a partnerhsip (50/50). The relationship deteriorated, and sister sought to dissolve the partnership. The court gave a price on the assets for brother to buy. Joan was pissed and sued saying this should have been a forced sale Holding: Since the dissolution was court-ordered, the partnership must be liquidated. McCormick cannot be compelled to accept a buyout. All partnership assets must be converted to cash and surplus distributed to the partners. The trial court’s ruling is reversed to the extent that it ordered a buyout, and the case is remanded for further proceedings.
▪ Question: Should the ranch have been force sale, or was it correct in the court giving a price?
Holding: MCA [RUPA § 801], sets forth the events causing dissolution and winding up of a partnership, and includes the following:
o in the absence of a partnership agreement to the contrary, the only possible result under RUPA was for the partnership assets to be liquidated and the proceeds distributed between the partners proportionately.
o The court reasoned, however, that the term “liquidate” had a variety of possible meanings, one of which was “to assemble and mobilize the assets, settle with the creditors and debtors and apportion the remaining assets, if any, among the stockholders or owners.”
o COURT SAYS that the language is clear that liquidation means to sell it off.. bc it says that creditors are to be paid back and net profit to be distributed.
• Was there supposed to be an accounting to determine the assets? Yes.. it should have been done. This is how you know what to sell and who to pay back.
• Why wasn’t she willing to take half the appraisal amount? She doesn’t believe its enough.. OR there is a personal dynamic in which the two just hated eachother..
• The default back drop.. it was dissolution which leads to a winding up and a liquidation…
• Highlights the two paths: Dissociation.. continue on and buy out.. or a dissolution where you get a winding up and a liquidation…
New Partnership HYPO: Under their partnership agreement X, Y, and Z agree to share losses 60/20/20. Creditor has a $100k claim against the partnership, and sues only X, seeking to recover the entire amount. Can X defend to the creditor by saying, “At most, my liability is $60k”? In a partnership you are JOINTLY AND SEVERABLY LIABLE.. SO.. no.. you are liable for the 100k. But they could get reimbursement/ idemninfcation for the 20k from each other person.
Wrapping up GENERAL PARETNERSHIPS
- Partnership agreements can:
o Change governance Rules (ie voting and mgmt. rights)
o Define scope of fiduciary duties so long as not manifestly unreasonable
o Establish financial rights between partners (during termination and dissolution.. can address a buy-out..
- Partnership agreements cannot
o Completely eliminate fiduciary duties
o Alter third parties rights
o More at RUPA 105..
Other Partnership Forms (LPs, LLPs, LLLPs)
Overview
• Each of these partnership forms requires filing a certificate with the secretary of state in the jurisdiction chosen by the parties in order to accomplish formation (and if this is not done or not done correctly, the parties may have inadvertently formed a general partnership).
• LP = general partner + limited partner. LP gets limited liability but GP does not.
• LLP = general partners only. GPs get limited liability
• LLLP = general partner + limited partner. GP and LP get limited liability.
• LIMITED PARTNERSHIP: Silent/passive partners without management rights. Not personally liable unless they participate in management or control of the LP (old “control rule”- Cal.); current uniform act has modified to not personally liable except in extraordinary circumstances.
▪ One or more general partners and one or more limited partners
o General Partners: active in management
o Limited Partners: silent investors
▪ A signifier
o Ex. “LP”
▪ Formal filing
o Must have a certificate of limited partnership
▪ Proportional shares of profits and losses
o Default Rule: Partners in an LP share profits and losses in proportion to their respective capital contributions
▪ Separation of ownership and management functions
o Limited partners are passive investors with essentially no management power and no authority to act as agents for the business. They invest money in return for transferable interests in the partnership.
o General partners are the active managers, empowered to carry out the limited partnership’s business. Because of their management role, only general partners owe fiduciary duties of care and loyalty to the partnership.
▪ Limited Liability
o Limited partners not personally liable for the obligations of the limited partnership.
▪ Because limited partners do not control how the business is run, the law provided that their liability would be limited to the amount of their investment.
▪ Exception: under the old rule, limited partners will be personally liable if they participate in management or control of the LP
o General partners jointly and severally liable for the limited partnership’s obligations.
▪ Limited Liability Partnerships
o Definition: General partnerships that have elected to be treated as limited liability partnerships (LLPs) and filed a form with the secretary of state.
o Characteristics:
▪ A signifier
• Ex. “LLP”
▪ Formal filing
o Partners shielded from personal liability for partnership debts
▪ Partners are shielded from personal liability for all partnership debts.
▪ A partner remains personally liable for her own wrongful acts
▪ EXAMPLE: A partner in a law firm structured as a LLP remains liable for her own malpractice, and the partnership itself can be held liable for such malpractice, but the other partners cannot be held personally liable for any shortfall.
▪ Limited Liability Limited Partnership
o Characteristics:
o A signifier
▪ Ex. “LLLP”
o Formal filing
o Similar to an LP, but general partners get limited liability
o Typically restricted (ex. not allowed in CA)
TOPIC 3: CORPORATIONS
Corporation: a legal person—a legal construct to pool money and labor—typically possessing the following attributes:
• Separate Entity
• Perpetual Existence
• Limited Liability
• Centralized Management
• Divisible Ownership
• Transferable Shares and Debt Obligations
A corporation can be Sued. Can only seek assets from the corporation. If the corp doesn’t have money.. then tough luck unless you pierce the corporate vail.
How a Corporation is Managed/ Centralized: In partnerships everyone gets to act as a decision maker. However in a corporation there is a board of directors who have the power to make decisions of the corporation.
▪ Why have this? Needs the separation of ownership from control to have limited liability.
What Corporate Law Does not Cover: Corporation law does not cover employees.. polluting.. etc.. corporate law only covers the internal governance of a corporation. Corporate law rather covers the interactions between
▪ the stockholders (aka “shareholders”)
▪ he board of directors, and
▪ the officers (aka “managers” or “executives”)
Comparisons of Partnerships and Corporations
| |General Partnership |Corporation |
|Formation |Informal; UPA, RUPA. |Formalities required; Certificate of incorporation, |
| | |bylaws, board of directors, minutes, elections, filings, etc. |
|Limited Liability |No. Unlimited personal liability. |Yes. Limited liability for shareholders. |
| |But partnership agmt can have indemnity provisions, |But creditors may seek personal guarantees and t |
| |can buy insurance, and other partnership forms offer |here is the veil piercing doctrine. |
| |limited liability to various extents (LP, LLP, LLLP) | |
|Free |No (default rule). |Yes, generally. |
|transferability (of|Just the “transferable interest” is personal property |Can sometimes be restricted. |
|interest/share) |that can be transferred; but partners can negotiate | |
| |and dissociate. | |
| |Partnership |Corporation |
|Continuity |Default is at will (dissolution by a partner |Default is indefinite/perpetual. |
| |expressing will to withdraw). |But can limit. |
| |Death of partner – dissociation. |Not tied to human life. |
| |Can agree to continuation agreements. | |
|Management |Decentralized (default). |Centralized (default). |
| |Each partner an agent and equal participation in mgmt |Directors and officers manage the corporation; |
| |is default; but can use exec comm. and limit authority|not shareholders. Separate and specialized functions. |
| |by agreement and notice to third parties. | |
|Cost |Zero. |Filing fees, typically lawyer fees, franchise fees, etc. |
| |But often good idea to hire a lawyer. | |
|Default Rules |Extensive. |More extensive. |
|Flexibility |Very malleable form for carrying on business; most |Not quite as flexible. |
| |rules are default. | |
|Tax |“Flow-through” (single). |Taxed as entity, so shareholders have double taxation |
| |Losses can be used by partners. |on distributed earnings; losses usable only by |
| | |corporation. [Exception: S Corporations] |
How is Corporation formed? The 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.
Stockholders are the equity investors
• Their ownership interests are reflected in the stock of the corporation.
• They elect a board of directors, who in turn select the officers who run the business.
• Shareholders have a few key rights, but they do not participate in managing the corporation’s business or affairs. They cannot act on behalf of the corporation.
The board of directors directs the affairs of the corporation
• Authority to act for (and to bind) the corporation originates in the board as a collective body.
• Directors have fiduciary duties to the corporation and the body of shareholders.
The officers handle the day-to-day management of the corporation and are under the direction of the board.
• The officers are appointed by the board. E.g., CEO, CFO, etc.
• They are agents of the corporation.
Picking the Board/ Key Functions
• By default, stockholders elect the members of the board (directors) at the annual stockholder meeting.
• Directors tend to be CEOs or other executives with full-time jobs and responsibilities at other companies. Corporate officers such as the CEO may also be directors.
• Directors have fiduciary duties (which we’ll study in detail).
• Subject to some limitations, the board has the power to delegate authority (e.g., it can appoint officers to run the day-to-day operations, it can delegate certain authority to committees of the board, etc.).
DECISIONMAKING by the BOARD OF DIRECTORS
• The board of directors takes action on behalf of the corporation either at a meeting at which a “quorum” is present or by written consent.
o Action at a board meeting (DGCL § 141(b)): “A majority of the total number of directors shall constitute a quorum for the transaction of business unless the certificate of incorporation (COI) or the bylaws require a greater number. Unless the COI provides otherwise, the bylaws may provide that a number less than a majority shall constitute a quorum, in no case shall be less than 1/3 of the total number of directors…”
o “The vote of the majority of the directors present at a meeting which a quorum is present shall be the act of the board of directors…”
o Action by written consent (DGCL § 141(f)):Authorizes a board to act without a meeting by means of written consent, but it requires unanimity.
Organizational Choices/Characteristics of the Corporation
• Sources of law:
o Each 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.
o While there is no federal law of corporations per se, federal statutes add a significant layer of corporate regulation (e.g., securities laws, Sarbanes-Oxley, Dodd-Frank).
• Choice of law:
o 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
• Key corporate documents:
o Certificate/articles of incorporation
▪ Terminology:
• Delaware uses the term “certificate of incorporation”
• California uses the term “articles of incorporation”
• Colloquial term is the “charter”
o Filed with the state in order to incorporate, must meet statutory requirements
o Bylaws
▪ Not filed with the state
▪ Set out the governing details of the corporation
▪ Typically longer than the certificate of incorporation and include governing rules for electing directors, filling director vacancies, notice periods and details for calling and holding meetings of shareholders and directors, etc.
Public vs. Private Corporation
• “Public” corporations are large firms with stock traded on public stock markets
o The shareholders typically do not expect to participate actively in the operation of the business; they are passive investors.
o There is a large amount of federal law that applies to public corporations (securities laws, etc.).
• “Private” corporations (also “close” or “closely held”)
o Not subject to public reporting requirements under federal securities laws
o 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.
o 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.
Internal Affairs Doctrine (A Choice of Law Rule)
• INTERRNAL AFFAIRS DOCTORINE: corporations 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.
o Exception—CA Long-Arm Statute. With the exception of publicly traded corporations, it makes “foreign” corporations with more than 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.
Qualification of “foreign” corporations to do business
• A 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 form and attach a certified copy of its certificate and/or a certificate of good standing from its state of incorporation, pay a filing fee, and appoint a local agent to receive service of process.
Delaware Corporate Law: The internal affairs doctrine has made it possible for a dominant body of corporate law principles to exist—Delaware corporate law.
Incorporation Process
1. Select state of incorporation. (CONSIDER INTERMAL AFFAIRS DOCTORINE).
2. Reserve the desired corporate name by application to the secretary of state or other designated state office.
3. Arrange for a registered office and registered agent.
4. 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).
a. May be incorporated for a purpose or “any lawful purpose”
b. 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.
c. PAY FILING FEES.
5. 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. (DGCL § 108) Also:
a. Appoint officers
b. Adopt bylaws (DGCL § 109)
c. Adopt pre-incorporation promoters’ contracts
d. Authorize issuance of shares, stock certificates, corporate seal, corporate account, etc. (use a checklist to be meticulous)
6. 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.
7. Plan for shareholder meeting as required.
Ultra Vires Doctrine
• Ultra Vires= “beyond the power”
• At common law, a corporation was limited to the powers enumerated in the purpose clause of its charter.
o At common law, a corporation was limited to the powers enumerated in the purpose clause of the charter
o Historically, if a corporation engaged in conduct that was not authorized by its express or implied powers, it was void. Over time, states began to allow corps to broaden (“any lawful purpose”)
• 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):
o 1. in a proceeding by a stockholder against the corporation to enjoin a proposed ultra vires act;
o 2.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);
o 3.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 relic.
EXAMPLE:
• A and B incorporate a business called Island Foods, Inc. (“IF”) and both become shareholders and officers in the corporation. IF’s certificate of incorporation includes a purpose clause stating that the corporation was formed for the purpose of making and selling traditional Hawaiian food. The business is successful, and later, in an attempt to expand the activities of the business, A, on behalf of IF, enters into a contract with C to buy a tour boat. When A tells B about the deal, B is angry and brings an action to enjoin the purchase.
• Here, a court would grant an injunction only if C knew that the transaction was beyond IF’s purpose clause.
Promoter Liability
• When does a corporation become incorporated? The date the articles are filed (or later if a different date is specified)
• A “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.”
o E.g., identify and solicit investors, arrange for space/facilities, hire employees for the entity, enter into contracts.
o 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.
• WHEN PROMOTERS ARE LIABLE
o Pre-incorporation:
▪ Promoters 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, that the parties intended the promoter to be a non-recourse agent or a “best efforts” agent
o To get this.. the law requires a clear showing to not hold the promoter liable.
o Post-incorporation:
▪ Corporation is liable on the contract only if the corporation adopted it.
• Can be express (e.g., formal board resolution) or implied (e.g. if directors or officers knew of and acquiesced in the contract).
• Can also be implied if they knew of an acquiesced in the contract.
▪ Promoter remains liable unless (all three): (see Moneywatch)
• Corporation is formed;
• Corporation adopted the pre-incorporation contract; and
• The 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. Wilbers [no novation to get promoter off the hooke. Was liable. Also substituting name on lease does not serve as a novation. Need clear intent of novation]
• Wilber signed articles of incorp for j and j adventures inc.. after moneywatch agreed to put a name on the lease to j and j.. wilbers did not request a release on personal liability.. defaulted.. is he personally liable? Yes
• A promoter continues to be liable unless the parties intend to make a substitution..
• Court didn’t find the fact that they cashed checks from the corporation once formed.. enough to constitute a release.. they just wanted their rent money
• Court says it comes down to intent. Was there intent for a novation? And the court says no. There is evidence to the opposite. Simply substitutiong party names des not suffice asa novation.
PROMOTER FIDUCIARY DUTIES
• Promoters of a yet-to-be-formed corporation have some fiduciary duties to the entity, the other promoters, and investors:
o They have a duty of good faith and loyalty.. which means they wont engage in shady business which hurts the stock of those investors
o Promoters must deal with the entity in good faith. This requires promoters to act fairly in transactions they enter into with the corporation.
o Promoters must disclose relevant information, like opportunities and conflicts vis-a-vis the entity, to other relevant parties. (e.g., no secret profits)
SUBSCRIPTION AGREEMENTS
• = An offer to purchase shares from a corporation. Subscriptions can be made to existing corporations or corporations to be formed.
o 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.
o They are not enforceable until they have been accepted by the corporation.
DEFECTIVE FORMATION (DE FACTO CORPORATIONS AND CORPORATION BY ESTOPPEL)
De Facto Corporation - THIS IS UNCOMMON NOW.. BC of ONLINE ENCORP.
o Elements:
▪ Statute for valid incorporation available;
▪ Good faith attempt at incorporation; and
▪ Good faith use of corporate form in a transaction with a third party.
Corporation By Estoppel- See Southern Gulf
• Equitable doctrine applied where court determines it would be unjust to allow a party to escape liability by denying corporate existence (i.e. because they have previously recognized or dealt with the business as a corporation).
• Result: The corporation is only considered a corporation as between the two parties involved, not third parties
Example: Southern Gulf v. Camcraft
• FACTS: Southern gulf contracted with camcraft to build a boat for them. Camcraft defaulted in the process of building and sued to get out of the agreement after a suit by southern gulf for breaching the k. Apparently southern gulf had not been incorporated at the time, in the virgin islands, as they said they had. So camcraft saught to make the contract void basically because the status was not as it appears.
• HOLDING: The court says though, that this type of estoppel should not make a k void. It goes against justice.
• The appellate court suggested that Barrett might have been able to enforce the contract in his individual capacity. Under what legal theory could Barrett have done this? Promoter is a version of agency law… agent may have agreed to be liable OR if P isn’t real, and exceeded scope, than an agent could be contracted. Also could have enforced via promoter liability.
CAPITAL STRUCTURE (BASIC INFO ON STOCK AND DIVIDENDS)
• Corporations raise money (“capital”) to fund their business by issuing debt and equity securities (the “capital formation” process).
o These securities are long-term contingent claims on the corporation’s assets and future earnings, issued pursuant to formal contractual instruments.
• Corporations with existing operations often fund their business “retained earnings” (which just means income retained by the corporation).
Corporations have a “capital structure,” consisting of 2 basic types of securities:
1. Debt
• 3 basic forms: bonds, debentures, and notes.
• Holders of debt securities are creditors of the corporation
• Debt 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.
2. Equity
• A corporation issues equity in the form of shares of stock
• Equity 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 satisfied
• The 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.
EQUITY TYPE: STOCK
• Many 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.
Stock type: COMMON STOCK
• The most basic of corporate securities. The default.All corporations have common shares.
• Voting Rights: Typically, common share holders have the power to vote to elect the board of directors and to vote on other matters that require shareholder approval (e.g., amending COI, mergers if structured in certain ways, etc.). Voting rights can be varied.
• Claims on asset: Common stockholders have the “residual claim” on the assets of the corporation (debt and preferred stock would typically have a right to be paid first if the corporation is liquidated).
• Consequence: Corporations are rarely liquidated, though, so common stock generally represents a permanent or long-term commitment of capital to a corporation. If stockholders want out of their investment they “exit” by selling their stock to someone else who buys it at a price that reflects the corporation’s then-current value.
Stock Type: PREFERRED STOCK
• Comes with certain contractual “preferences” such as senior economic rights, dividend preferences, liquidation rights, etc. (Hybrid in this way between having some features of common stock and debt.)
• Essentially contractual in nature. Rights must be in the COI.
• Voting Rights: the same as common unless enumerated differently in the COI.
• Claims on Assets: Preferred stock sometimes represents a permanent commitment of capital and sometimes not – in the latter event, the shares will be “redeemable” for some specified amount. (Right to redeem may be held by the SH or by the corporation or both.)
• Consequences: Preferred stock sometimes represents a permanent commitment of capital and sometimes not. In the latter event, the shares will be “redeemable” for some specified amount. (Right to redeem may be held by the shareholder or by the corporation or both.)
DECISIONS ABOUT CAPITAL STRUCTURE
• Different capital structures reflect differing allocations of control, risk, and claims on the corporation’s income and assets.
• There is no one-size-fits-all optimal structure.
o Various considerations, e.g.:
▪ Taxes (for example, interest paid on bonds is deductible but $ paid in dividends is not)
▪ Leverage (Will the corporation be able to pay the agreed upon interest when it comes due? Leverage can increase potential for additional gain or for bankruptcy depending on corporation’s income and what it will do with the borrowed money. “Leverage increases risk—both on the upside and downside.”)
▪ Market (How much money needs to be raised for the corporation? What will investors buy? On what terms?)
Potential Tension in Capital Structures
• In preferred v. Common.. you see preferred may have some incentives to take on less risk.. when a common stock may ask to take on more risk.. since they have lest to lose. See Equity-Linked Investors
Equity-Linked Investors, L.P. v. Adams
• Facts: There were investors with proffered stock who’s buy out value was greater than the value of the company, and common stock holders. The companies mangers wanted to take out an additional loan, which subordinate the preferred stock holders, and bring what their recoup even lower. The common stock owners stand to lose nothing more. But preferred stand to take additional losses.
• Question: was this a breach of fiduciary duty? NO
• Holding: Companies managers are doing what it can do to survive the storm.
• What is a liquidation right? Right to get shit off the liquidation first.
• What did the court conclude? BJR.. thinking of the common stock holder and taking out more loans is okay. Not necessary to have to favor one class of stock over the other.
ISSUING STOCK
• Much of the law governing the issuance of stock is federal and state securities laws.
o 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.
• To validly issue shares, the board must authorize the issuance of shares and the corporation must receive appropriate consideration. DGCL § 152.
1. Board needs to check to see if there is enough headroom to issue stock.
2. The appropriate number of shares must be authorized in the certificate of incorporation (COI).
a. If there are not enough authorized shares to do the issuance, the COI must be amended. DGCL § 242. Requires the board to adopt a resolution setting forth the proposed amendment, call a properly-noticed special meeting of the SHs or put up for vote at next annual SH meeting, receive a majority of outstanding shares voted in favor of amendment.
3. 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.
VOCAB: Par Value
• Historically, shares all cost the same (the “par value”)
a. This protected against discriminatory stock pricing
b. Par value reflected the amount paid and the actual value of the stock
c. But in reality, “watered stock” was an issue
i. If par value stock was issued for less than its value, the original buyer and directors who authorized the sale could be liable for the difference
d. Today, there is a more liberal way of construing par value
• Legal Capital: A corporation is required to keep a cushion in the corporate treasury to protect debt holders (pg. 268).
• Par Value: The minimum price per share for the stock. This is not the actual value but the minimum amount it could be issued for.
a. Many states allow corporations to have no par value attached to its stock.
VOCAB:
• Authorized 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”).
o 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.
OPTIONS
• An option is the right (but not obligation) to buy or sell something in the future.
• They are contingent claims: gives the holder the contractual right to buy or sell, but not a contractual obligation.
• “Call option” = the right to buy shares (typically by a certain date at a certain price).
• EG STOCK OPTION.
• Often issued as part of an incentive compensation package.
• Often subject to a “vesting period” in which a certain portion of the stock options vest over time, giving the holder the right then (once vested) to purchase a certain number of shares at the “strike price”/ “exercise price” before the expiration date.
• “Put option” = the right to sell shares (typically by a certain date at a certain price).
HOW DO PEOPLE MAKE MONEY FROM INVESTMEN IN A CORPORATION?
• Selling out or
• Dividends.
DIVIDENDS
• A 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).
o 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?
• Dividends can be paid out only of a corporation’s surplus (the legal capital test) (DGCL § 160)
o Surplus = Total Assets - Total Liabilities - Legal Capital
o If no surplus, dividends can be paid out of net profits of preceding fiscal year
Can shareholders compel a corporation to declare a dividend? Typically the answer is no. shareholders cannot force as long as the board shows that they were acting in good faith. (Applying the BJR)
What happens when shareholders challenge a board decision to issue or not issue dividends?
• Litle v. Waters (closely held private corporation and an “interested director” as to the decision not to issue a dividend – fairness review)
• In this.. two corporations.. two share holders.. one was the 2 thirds shareholder who had put in the capital.. and the other was the person who put in the sweat. Majority handled himself inequitably, thus applied a fairness review. Not the usual BJR.
• Kamin v. American Express (public corporation and board’s decision given business judgment rule deference)
• DLJ stock tanked.. and no amex was holding this stock that went down in value. AMEX decided to issue the stock out as a dividend. Overall value to investors is decreasing because if AMEX sold the stock at a loss, they reduce tax liability. Now they have a crap asset+ tax liability. So the shareholders sued. AMEX gets protection of their business judgement.
STOCK SPLITS
• A division of the outstanding shares into more shares.
• Why? To permit the transfer of smaller percentages of ownership
• Done via dividend
• Reverse stock split also possible
Reverse stock split: This is a reverse of a stock split.. this requires amending the certificate of incorporation.. If you are so low in value.. you are able to reverse split.
o When splitting, boards decision. Don’t need to amend if there is enough OUTSTANDING..
o For a reverse split.. need an amendment.
STOCK REPURCHASES
• Repurchased stock = “treasury stock” (authorized, issued, but not outstanding stock that can be re-issued by default rule)
• What are possible reasons why a corporation would repurchase its own stock?
o Undervalued stock. So a board will buy it back for value.
o Too much cash in company. So buy back equity.
o Changing debt to equity.
o If you want to get rid of a particular shareholder.
• Why does someone sell the stock? Bc the offer that is tendered is worth more than the street value!
• Rules on repurchases?
o DGCL § 160 – bad faith or fraud, otherwise bjr.
o Case Illustration: Klang v. Smith’s Food (in absence of bad faith or fraud on the part of the board, the court defers to the board’s determination of surplus)
LIMITED LIABILITY AND PIERCING THE CORPORATE VEIL
General Rule: 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 liable through a personal guarantee.
• What are the rationales for limited liability? Allows for economic growth
o Why? This encourages capital formation; creditors can protect themselves against risk (higher prices, interest rates, etc.); allows individuals to diversify by holding stock in many corporations
o WHY DO CREDITORS AGREE TO THIS? They can bargain and get a better interest rate or get a personal guaranty.
• However for tort victims it puts a cost to tort victims some would say it’s a social critique that it goes against to disadvantages populations as a society this does come up.
• There is a CL exception to limited liability and it is called PIERCING THE CORPORATE VEIL.
PIERCING THE CORPORATE VEIL
• Piercing the corporate veil (PCV) is an equitable doctrine created by courts to “prevent fraud and achieve justice.” It allows a plaintiff to be able to piece through limited liability and sue a shareholder for damages caused by the corporation.
• Un predictable but courts generally pierce. When there is an injustice in some way beyond to not paying the creditor. Fact specific cases.
• States vary in their PCV tests. No single test prevails.
• Nearly all PCV cases involve closely-held corporations (apart from enterprise liability, which we’ll discuss soon).
• Contracts disputes can lead to piercing.. Contracts where people are willing to pierce occur when people are being deceived in a way. If they were sophisticated the court wont pierce however.
Big Picture- General Principle/ Legal Standard [when you can pierce]
• 1. Unity of interest and ownership /Control or domination (aka “alter ego”)
o Frequently discussed factors or considerations:
▪ (1) Failure to observe corporate formalities
▪ (2) Comingling business and personal funds or assets
▪ (3) Undercapitalization of the business
• Insurance counts.. a way to get capitalization of a business
• 2. And refusing to allow PCV would sanction fraud or promote injustice
o Deceit or other wrongdoing, some element of unfairness or wrong beyond a creditor’s inability to collect
▪ AN UNSATISFIED JUDGEMENT ALONE IS NOT ENOUGH… Why isn’t this enough? The exception would swallow the rule!
• 3. Sometimes there is a another prong.. that there must have been a proximate cause to the plaintiff.
NOTES
• Courts state different factors on prong/element 1, but it generally boils down to control (often implicitly), lack of corporate formalities, intermingling funds or assets, undercapitalization. To pierce, you generally need at least 2 of these factors.
• Some courts expressly state the separate prong/element 2 with sanctioning fraud or promoting injustice; sometimes the analysis ends up being very similar anyway and effectively collapses into analysis of the unity factors or a holistic appraisal.
• Courts sometimes also state that the control or wrongdoing must have proximately caused the injury or loss to plaintiff.
CALIFORNIA TEST
• “To invoke alter ego, two conditions must be met:
o 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
o 2) there must be an inequitable result if the acts in question are treated as those of the corporation alone.”
Two Ways to Pierce: There is vertical liability—which is piercing up to the shareholder. And then there is horizontal liability—of suing whet here are multiple subsidiaries, and getting at those other subsidiaries.
Walkovsky v. Carlton [VERTICAL PIERCING]- Tort
• Facts: Cab business owner owned 10 cab companies with only 2 cabs ine ach company, and has minimum insurance for each. Plaintiff was hurt and sued. Tried to piece to the owner to collect the damages.
• Question: Can he pierce? No PCV
• Holding
o What test does the court state for piercing the corporate veil? PCV allowed whenever necessary to prevent fraud or to achieve equality.
o Says they presented no evidence that the business was undercapitalized or that personal assets have been intermingled. Also was insurance.
NOTES ON Incorporation
• Is it improper to incorporate your business for the express purpose of avoiding personal liability? NO THAT IS THE POINT.
• Is it improper to split a single business enterprise into multiple corporations so as to limit the liability exposure of each part of the business? [recall Southern-Gulf Marine] .. no..
Radaszewski v. telecom corp (another tort case)
• Facts: Plaintiff his by defedents truck. Corp not capitalized, but had insurance. Wants to pierce to recover damages from the parent company.
• Question: Is Telecom Corp Liable for Contrux? NO.
• Holding: Plaintiff needs to show three things: 1)Parent company has control over the subsidiary. Like complete control, not just financial. (2)Such control must be meant to fraud or do wrong. (3) The control or breach of duty must cause the injury.
o Being undercapitalized is [ro,a facie showing of number 2. But unfortunitly there was not ths bc there was insurance. Even if it was shady. They owned the insurance too.. but that’s a common practice.
• Ultimately says.. the point of limited liability is to protect subsidiarys who go broke.. so if you have a problem, talk to the legislature..
Therberge v. Darbo (contract)- Sophisticated parties not eligible to pierce.
• Facts: Business men went in on a JV, it didn’t do well. There were a number of agreements, some with person guarantees some with not. One with not the parties tried to sue to pierce the corporate vail.
• Question: Was this an alter ego? No.
• Holding: The higher court, however, says that Every party involved in these transactions were sophisticated. The fact that they did not ask for a personal guarantee from Small pretty much shows that they were dealing with the corporation only, not Small as well.
Piercing in Corporate groups (aka Enterprise Liability)
• Enterprise liability allows a plaintiff to hold a parent corporation financially responsible for the acts of a subsidiary.
o Occurs where there is a parent-subsidiary situation or where there Is a corporate group with a parent and multiple subsidiaries that are affiliates of each other (vertical or horizontal piercing)
o Depends on proof that the separate identities of the corporations were not respected. If successful under this theory, the plaintiff could recover from the other corporation but not from the shareholders
Gardemal v. Westin Hotel Co. [common officers not a PCV issue]
• Facts: Plaintiff went to a Westin Mexico on vacation. Asked concierge for a good place to swim. Got thrashed at swimming spot. Suing Westin Mexico and Westin US.
• Question: Is MX an Alter Ego? No
• Holding: Not an alter ego.
• Despite common manuels, officer, etc, there was a unique banking system and sufficient corporate formaility. Not an alter ego. Westin Mexico was its own thing. Not underfunded.
OTR Assocs. v. IBC Services, Inc. (BLIMPIE)- Reconcile with therbage bc they POSED as blimpie.. not just unsophisticated. But some level of fraud.
• Facts: Blimpe subsidiary who leases out all the blimpie real estate. This company defaulted and stoped paying a lease they had made to a real property owner.
• Question alter ego?
• Court says yes.. reason being I that it had complete control over it by blimpie, and in fact posed as blimpie.. and thus is seeking an unequitable outcome of protection.. when pretending to be bigger.
• Rule on 316… on top… Two prong test.. same old one… basically CONTROL.. and INEQUITABLE.
THE ROLE OF DIRECTORS & OFFICERS (MANAGING THE BUSINESS AFFAIRS; FIDUCIARY DUTIES)
• Directors are fiduciaries that shall act in good faith and with conduct reasonably believed to be in the best interests of the corporation.
• They owe a duty of care (DOC) and a duty of loyalty (DOL) (which includes a duty of good faith) to the corporation and its shareholders. Generally, outside of these fiduciary duties.. we get the business judgement rule.
• Stemming from these duties, directors also have a duty of disclosure (aka, a duty of candor).
• In Delaware.. the Fiduciary duties are not codified.. these come from case law.
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.
Standard of Conduct vs. Standard of Liability
• We have a standard of conduct.. which we should aspire to in the model business corp. act
o 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.”
• But what creates liability is the STANDARD OF LIABILITY
o 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.
The Business Judgement Rule
• Intro
o 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).
o 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.”
o 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). We will see from the case law what the standard to rebut BJR is for DOC cases.
o 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 decision was unsound (e.g., were directors grossly negligent in failing to inform themselves before making a decision?).
o “corporate waste” claim that plaintiffs can bring. Very hard for plaintiffs to win. Standard is “a transaction so one-sided that no reasonable business person would enter into it.”
▪ The standard of judgment on a waste claim is that tit is so one sided, that no one would enter.. then
o BJR protection is not available in non-feasance situations (failure to perform minimal levels of oversight or making a decision at all).
o Policy rationales for the BJR? Keeps courts from making business decisions. HELPS TO AVOID BUSINESS DECISIONS CHILLING. Board of directors are in a better position to make judgements than courts.
• Reliance on Experts
o In 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.
o Under DGCL § 141(e), directors are entitled to rely on opinions and reports so long as such reliance is reasonable and in good faith.
• Notes about Fiduciary Duties
o In general, officers owe the same fiduciary duties as directors.
o There is currently some uncertainty in the law as to the standards that apply, however, and there are a few other notes to make about differences, so we’ll come back to addressing officers’ duties at the end.
o We’ll also later discuss how sometimes certain shareholders can owe fiduciary duties.
• Three Challenged Business Decisions
Kamin v. American Express: Same analysis . DOC claim.
Shlensky v. Wrigley: No lights in Wrigley Field for night games. DOC
• Facts: Minority stakeholder in the cubs suedthe majority stakeholder in the cubs for breach of fiduciary duty and negligence because the teamw as losing money and feld the reason for the loss was that they did not install light in the baseball stadium to allow for night games.
• Question: Was this a breach of fiduciary duty? No..
• Burden on Plaintiff to show gross negligence.. self dealing or fraud. Didn’t show it.
• Not following the crowd doesn’t make one negligent. BJR.
Smith v. Van Gorkom: Cash-Out Merger Proposal DOC claim.
• Facts: Corporation sold itself without much deliberation on value of company, or other deals outside of the sale offer.
• QUESTION: Was there a breach of the DOC. Yes.
• Holding:
o Who are the Plaintiffs? Class action from the shareholders.
o Who are the defedants? VG
o What What action is being challenged? Sale of the business. No DOC in deciding the sale.
o Shareholders claimed that the board was Uninformed regarding the terms and implications of the merger agreement. Also Uninformed as to the intrinsic value of the company
▪ Mere 2 hour meeting w/o prior notice/opportunity to read agmt
▪ 20 minute oral presentation, not “report” under § 141(e)
▪ No outside opinion on fairness by expert
▪ No valuation of ITC
o HOLDING IN VAN GORK
▪ The directors had a duty to: “inform themselves of all material information reasonably available to them” before making a decision. If not.. CLEANS the decision with a ote by the shareholders.
• Take aways from Van Gork
o Who has burden of proof on this issue? Plaintiffs must rebut the presumption.
o What must that party prove? Flawed process
o Does the court review the substance of the decision? No.
o DGCL § 141(e) provides a defense for directors who rely on reports from officers. Why didn’t § 141(e) apply here? The reliance on expert opinion here was not RELEVANT to the DOC question at hand (shareholder price).
o Why did lightening strike in Smith v. Van Gorkom? Prof thinks.. why did this lightning strike? …. Bc the process was so flawed… and it is the final chance for a shareholder. Finality of a sell.
o How often do directors lose on these grounds? VERY RARELY.
o In future cases, what steps should boards take in order to avoid liability for uninformed decision-making? Now you have to get fairness opinions.. from bankers.. talk to corporate lawyers.. meet more than 2 hours..
o Who has the burden? Plaintiffs had to rebut the BJ presumption.. this needed to show GROSS NEGLIGENCE..
Aftermath from Van Gork creation of 102b7 (Director exculpation)
• D & O insurance rates began to skyrocket
• Many directors quit/declined appointment to boards
• Delaware legislature enacted DGCL § 102(b)(7)
• GDCL Section 102(b)(7); DIRECTOR EXCULPATION for DOC
o §102(b) A corporation may include in its charter
▪ (7) 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.
Vocab:
• Control Premium: if you are buying all of the company’s outstanding shares, you are buying control of the company. Can charge more.
Francis v. United Jersey Bank (NO BJR b/c NONFEASENSE NOT MISFEASENSE.. breached DOC)
• Facts: Mom took over the family business when husband died. Was warned that her sons would rip off the business. She was an alachoholic and didn’t watch the sons. Sued for breach fo duty of care after they stole money from the business.
• Holding: Breached her duty .. should have paid more attention to the financial status.. didn’t take in to consideration the condition she was under..
• No BJR here. Why? Non-feasense is not a business judgement.
• A SENTINAL ASLEEP AT HIS POST NOTHING… Any small action could have stopped the outcome.
REVIEW
• What was the challenged board decision in Kamin v. American Express? What did the court rule and why? BJR.. applies.. no indication of gross negligence.. they didn’t have the best decision…
• Same questions as to Shlensky v. Wrigley…? Ordinary light in Wrigley field… protected by the Business Judgement Rule… there was a business decision hat youa re challenging.. this puts on you the burden to put on the showing of gross negligence…
• In Van Gorkom, what standard did the court apply in concluding that the directors breached their duty of care? Who had the burden of proof on that issue? .. Same things.. bringing a duty of care claim.. BJR applies.. this put the standard on NJR… this succeeded in showing gross negligence….
• Post-Van Gorkom, what would you advise directors in similar circumstances to do to avoid breaching their fiduciary duty of care?
• What does DGCL § 102(b)(7) provide? Director Exculpation
BANANAS HYPO
Bananas Corporation has been earning record revenues from its popular gadgets and has accumulated an uncommonly large amount of retained earnings. The board of directors of Bananas Corporation reviews relevant materials and discusses what should be done with this money, including the possibility of declaring a stock repurchase or a dividend. The board decides to do nothing for now and to revisit the issue at the next board meeting.
Is this protected by the BJR? Making an informed decision… can still protect via the BJR.. its NOT non feasesnse. This is a decision that gets BJR… if they get BJR.. then the plaintiff shareholder would have to show gross negligents…
Corporate Purpose, Corporate Social Responsibility, Charitable Giving, and Corporate Political Activity
• Overview-- Conflict between…
i. Shareholder Primacy: the corporation is seen as the private property of stockholders
1. See Dodge v. Ford Motor Co.
ii. Stakeholder Theory: the corporation is seen as a social institution, operating for the benefit of the community, employees, customers, and shareholders
Dodge v. Ford Motor Co. [basically saying good faith breach.. to not pay dividend.
• Facts
o Ford decided to only do a 60% dividend on the cap.. when previously was basically giving out all the profits. Said he was doing it to invest into a smelting plant to verticalize the companies products. Dodge brothers who each had 10% of the value of the company were pissed they didn’t get dividends. And sued.
• Question: Is there a right to make money or for social justice? Make money.
• Holding
o The court ruled that the board of directors must pay out a dividend.. this is an ABORATION in the law of dividends.. usually its an ordinary business decision.
o Reasoning: A business exists to conduct business on behalf of its shareholders. It is not a charity to be run for its employees, or neighbors. Basically saying this was a breach somehow of the discretion.
o As far as the plant.. they said HEY.. made a business decision.. so it gets BJR.. no funny business… it was made in good faith.. so it would force a dividend..
o NOTE: Why doesn’t BJR apply here?
▪ This is an anomaly in corporate law
▪ Court says that although decisions by board are usually discretionary, courts will intervene to enforce a dividend if the refusal is such an abuse of discretion as to constitute a fraud or breach of good faith
NOTE: Constituency Statutes—growing from corps wanting to do extra things.
• A majority of states have “constituency” statutes that expressly allow (but do not require) a corporation to consider stakeholders’ and other constituencies’ interests alongside shareholders’ interests.
• DE and CA do not have constituency statutes.
o Pretty pervasive as a traditional view.. that corporations are meant to serve the shareholder..
CORPORATE CHARITABLE GIVING
• General RULE: All 50 states have statutes providing for corporate authority to make charitable contributions.
o DE and CA say..
▪ DE- not expressly dispensing of corporate benefit
• DGCL § 122: “Every corporation created under this chapter shall have power to: . . .”
o “(9) Make donations for the public welfare or for charitable, scientific or educational purposes, and in time of war or other national emergency in aid thereof;”
• Note the language of the DGCL doesn’t expressly dispense with the requirement of a corporate benefit.
▪ CA
• California Corporations Code § 207: expressly getting rid of corp benefit.
o “Subject to any limitations contained in the articles and to compliance with other provisions of this division and any other applicable laws, a corporation shall have all of the powers of a natural person in carrying out its business activities, including, without limitation, the power to: . . .”
▪ “(e) Make donations, regardless of specific corporate benefit, for the public welfare or for community fund, hospital, charitable, educational, scientific, civic, or similar purposes.”
Challenging Charitable Donations
• General Rule: Reasonableness Test and BJR.
o See Theodora v. Henderson
▪ The Foundation was a legitimate charitable organization recognized by the IRS
▪ (Statutory maximum) The corporate gift was within the federal tax deduction limitation of 5% of the total income.
▪ (Benefit taxes) The gift reduced the company’s taxes by $130,000, which increased the balance-sheet net worth of stockholders of the corporation.
▪ ( overall benefit) The relatively small loss of income otherwise payable to shareholders was "far out-weighed by the overall benefits"
• THEODORA HOLDING CORPO v. Henderson [ in Delaware start with reasonableness of the fit.. then go to BJR]
o Facts: Henderson had a controlling interest in Alexander Dawson, Inc. Defendant's ex-wife owned a large amount of the corporations’ stock through Theodora Holding Corp. Over the years, Henderson caused Alexander Dawson to make charitable contributions to the Alexander Dawson Foundation, a legitimate charitable organization recognized by the Department of Internal Revenue. In 1967, Alexander Dawson had a total income of $19,144,229.06. In April of the same year, Henderson asked the board to approve a gift of company stocks valued at $528,000 to the Foundation to finance a camp for under-privileged boys. Although one director objected, Henderson got board approval of the gift by getting rid of five directors. Theodora Holding Corp. brought suit against Alexander Dawson, Inc. and Henderson challenging the gift.
o Holding: This test of the validity of a charitable gift by a corporation is that of reasonableness. Here, the charitable gift is reasonable and valid.
o Reasoning: The Foundation is a legitimate charitable organization recognized by the IRS and thus the gift to the Foundation is a charitable donation. The $528,000 corporate gift was well within the federal tax deduction limitation of 5% of the total income. In addition, the gift reduced the Alexander Dawson unrealized capital gains taxes by $130,000, which increased the balance-sheet net worth of stockholders of the corporation. The relatively small loss of income otherwise payable to shareholders is "far out-weighed by the overall benefits" of the gift, which will provide under-privileged young people with rehabilitation and education.
AP Smith v. Barlow
• AP Smith was a company that made valves on fire hydrants. The board decided to make a $15k donation to Princeton. The shareholders questioned this decision. The board said this was a good investment and within their discretion. The court held the corporation could make this gift. The corporation cannot give an unusually large gift or to a pet charity. There should be some benefit, broadly construed, to the corporation.
• Holding: Plaintiff can give money to charities providing that the total does not exceed the statutory maximum of 1% of capital and surplus, and the institution receiving the money does not own more than 10% of the company stock.
Citizens United v. FEC
o Corporations have independent first amendment rights to make political expenditures
o Procedures of corporate democracy protect dissenting shareholders
o Corporations have the power to make political expenditures. If these expenditures are challenged, they would be tested under the business judgment rule (they are considered business decisions).
Recap Questions
o Can a corporation choose to offer only daytime baseball games? Yes. BJR
o Can a corporation give to charity? Yes, reasonableness and BJR.
o Can a corporation retain earnings despite shareholder wishes otherwise? Usually but subject to BJR.
o Can a corporation choose to make an independent political expenditure? Yes.
o ***
o What are the underlying principles?
o Does the law dictate a particular view of the objectives of management?
Fiduciary Duties: The Duty of Loyalty
DUTY OF LOYALTY
• Requires that directors and officers act “in a manner the director reasonably believes to be in the best interests of the corporation.” RMBCA § 8.30(a)(2).
• Not about the care that they used.. but instead.. its about putting the interest of the corporation above the personal interests of the company..
• Analysis:
a. Plaintiff has the burden to show a conflict of interest
b. If plaintiff has shown a conflict, the burden shifts. The defendant has the burden to show that the transaction was fair to the corporation.
i. Substantive Fairness
ii. Procedural Fairness
INTERESTED DIRECTOR TRANSACTIONS
• When the person is on both sides of the deal. Requires directors or officers to act in the best interest of their corporation.
o The requisite benefit needs to be material.. one that is reasonable one that would be one to impair their objectivity..
• We still want These Interested director transactions, however. Directors can sometimes bring business opportunities to it.. a director may be more likely to do a fair deal..
• Modern common law upholds a transaction so long as the director proves it was fair to the corporation. In addition, there are interested director statutes. See Bayer v. Baron
o These statutes do not preempt common law, but overturn the old common law cases deeming conflicted interest transactions voidable per se.
▪ They also provide a procedure by which to “cleanse” interested transactions.
REMEDIED FOR AN IMPROPERT INTERETED DIRECTOR TRASDNACTION
• ENJOINING THE TRASNACTION
• SETTING ASIDE THE TRASNACTION
• DAMAGES
Bayer v. Beran
• Facts
o CEO’s wife was used in a radio campaign to help the company with PR. Was studies that showed radio was good for the company, and also an independent agency th at picked the talent for the radio.
• Question: Is this a breach of fiduciary duty and loyalty? No.
• Holding
o Was there an interested transaction? Yes- shifts burden from plaintiff to defendant.
o Procedural Fairness- yes
▪ Negotiated at arms length with an agent
▪ Form contract
o Substantive Fairness- yes
▪ Cost vs. Industry Standard
▪ Legitimate Interest of the corporation
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
o Procedural Fairness
▪ Negotiated at arms length with an agent
▪ Form contract
o Substantive Fairness
▪ Cost vs. Industry Standard
▪ Legitimate Interest of the corporation
o See Bayer v. Beran
INTERESTED DIRECTOR STATUTES
• Modern common law upholds a transaction so long as the director proves it was fair to the corporation.
• In addition, there are interested director statutes such as DGCL § 144 (and California has a similar provision under its corporate code, § 310).
o 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.
o DGCL144(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 (SEE BENIHANA)
• Informed: the interested director discloses the full extent of the conflict and the details of the deal to the disinterested directors
• There is an ambiguity in the phrase “approval by a majority of the disinterested directors.” The safe approach is to get approval by a majority of all disinterested directors, rather than just those present.
• See 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 –
• Unlike (a)(1), (a)(2) does not say “disinterested” shareholders
• However, case law has interpreted this provision to say disinterested shareholders.
o Fliegler v. Lawrence: Even though § 144(a)(2) doesn’t say “disinterested” shareholder approval, that is what is required for § 144(a)(2) to have a cleansing effect.
• Lewis v. Vogelstein: under what standard will a court review a breach of duty of loyalty claim where there was “informed, uncoerced, disinterested shareholder ratification of a transaction in which corporate directors have a material conflict of interest”? BJR.
o Shareholder ratification shifts burden of proof to show that the terms were so unequal as to amount to waste
▪ (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”
• See bayer v Baron. SUBSTANCE and PROCEEDURE.
o DGCL144(b): (b) Common or interested directors may be counted in determining the presence of a quorum at a meeting of the board of directors or of a committee which authorizes the contract or transaction.
▪ Pointing out one more thing about 144b…
▪ Hen a board dcides to enter in to a transaction.. in order for this to happen.. one you can have a properly convined meeting.. once you have a quoro.. you act sufficiently act to do something.. the other way is through unanimous written consent.. in calculating that first step. Even entered in to the transaction validly.. you can count the interested party in the quorum.. analyse weater the board..
• Fliegler v. Lawrence: Even though § 144(a)(2) doesn’t say “disinterested” SH approval, that is what is required for § 144(a)(2) to have a cleansing effect.
• Re; Lewis v. Vogelstein: Cleaning.
o Mattel directors were deciding their own comp packages. However voted and approved on by shareholders.
o What does the court say is the effect of § 144(a)(2)? BJR if satisified.
o In other words, under what standard will a court review a breach of DOL claim where there was “informed, uncoerced, distinterested SH ratification of a transaction in which corporate directors have a material conflict of interest” BJR via this SAFE HARBOR. Only thing you can ask then was.. is it waste.. but this is impossible to fathom.
• Harbor Finance Partners v. Huizenga
o Who has the burden of showing § 144(a)(2) was met? Defedant
o And if they succeed at showing § 144(a)(2) was met, what standard will a court apply to reviewing claim? BJR
o What would a plaintiff-SH have to show to be able to win? WASTE…
BOT v. Benihana (Delaware)
3. Facts:
a. Many of Benihana’s restaurants needed renovation, but the company did not have the money. Benihana hired Joseph to analyze the company’s finances and determine a plan of attack. Joseph recommended Benihana issue convertible preferred stock, which would give the company the funds necessary for renovation.
b. Subsequently, John Abdo (a Benihana board member) told Joseph that BFC Financial Corp. was interested in buying the convertible stock. Abdo was also a director of BFC, and he negotiated with Joseph for the sale of the stock on behalf of BFC.
c. At a subsequent Benihana board meeting, Abdo made a presentation on behalf of BFC regarding its proposed purchase of the stock. The Benihana board (defendants) knew that Abdo was a director of BFC and Joseph informed the Benihana board that Abdo had approached him about the sale on behalf of BFC. At the same meeting, the Benihana board voted in favor of the sale to BFC.
d. Two weeks later, BOT’s attorney sent a letter to the Benihana board, asking it to abandon the sale on account of concerns of conflicts of interests, the dilutive effect on voting of the stock issuance, and the sale’s “questionable legality.” The board nonetheless again approved the sale. BOT then brought suit against the Benihana board of directors, alleging breach of its fiduciary duties.
4. Holding: A transaction involving an interested director is valid if the material facts as to the director’s interest are disclosed or known to the board of directors and the board in good faith authorizes the transaction by an affirmative vote of the disinterested directors.
a. NOTE: Entrenchment; DGCL 144(a)(1)
b. TAKEAWAY: If there is a conflict of interest transaction challenged and the defendants point to 144(a)(1) and show that they have satisfied the requirements therein, the deal will get BJR (must prove that a majority of voters were disinterested)
5. Reasoning: Benihana’s board knew enough information about Abdo’s involvement in the transaction to validate the sale. Although the board may not have known the full facts at first, by the time the board approved the sale, it knew that Abdo was a director of BFC, that he was the proposed buyer, and that he had made the initial contact about the purchase with Joseph. This is sufficient information to deem the board knowledgeable on the material facts of Abdo’s interest. Therefore, because the board approved the transaction (without Abdo’s vote), it is valid.
a. THIS CASE STANDS FOR THE PROPOSTION.. THAT IF THE DEFEDENTS MET 144a1. That they were disinterested.. then ASA MATURE OF THE STAUTE> iits not VOID OR VOIDABLE.. and if ITS CHELLENGED>. THEN BJR> THEN ITS ON THE DEFENDANT TO SHOW THEY MET THAT AND THEY HAVE TO ACTUALLY SHOW IT.
CORPORATE OPPORTUNITIES
• Bars opportunities that in all fairness belong to the corporation. This basically deters appropriations of new business prospects that belong to the corporation.
• Forbids a director, officer, or managerial employee
o Targets: Directors and officers of corporation, Dominant shareholders who take active role in managing firm
o From.. Diverting business opportunities. Absent any waiver in the COI or proper disclosure.
• Reminder of the automotive v singer… machine shop case. Agency law analogous. In Meinhart v salmon.. analogy in Partnerhsip law.
• Guff v loft.. most famous case. Loft made candies and beverages.. goff went to Pepsi.. re-organize. Later sued by Loft for his stake in pepsi.. after he had reorganized it.. worth millions by the end… court found for loft Guff in taking the pepsi opportunity.. had only come to him bc of his experience for Loft.. and it was the retail network.. that put pepsi in a position to market itself nationally.. and then also the opportunity was in lofts business.The remedy was to disgorge his interest in Pepsi to Loft.. provides the early version of the current law test…
[pic]
Bros v. CIS- Outside director liability balancing test.
- Facts: Bros was on the board of a telecom company and also owened his own. An opp to buy another come bacme to him and he purchased the company. The company he was on the board of was going bankrupy. Shareholders however sued for breach of corporate opportunity.
- Holding
o Look at four elements for when an offer has to be brought via GUTH case:
▪ (1) the corporation is financially able to exploit the opportunity; [IN THIS CASE NO.. BC THE COMPANY IS IN BANKRUPSY}
▪ (2) the opportunity is within the corporation’s line of business; [Not technically.. but looking at it broadly.. its mostly a yes]
▪ (3) the corporation has an interest or expectancy in the opportunity; and [no bc they had divested themselves of other similar opportunities.. court notes that key players have said go ahead]
▪ (4) by taking the opportunity for his own, the corporate fiduciary will thereby be placed in a position inimicable to his duties to the corporation. [it would not be new competition for CIS.. and already knew of his exsisting company.. and had not issues there.. in the sense there was cellular .. didn’t seem to be a conflict that they minded.. not very strong answer…
o Didn’t present to board.. but could have and it would create a safe harbor. Not required to though if its not something the company would be interested.
o Bros was an outside director.. RELEVANT FACT HERE.. is that when someone is an outside director its possible that the opt came to them in some other mano they usually have some other expertise that’s making them get to get on the board…
Takeaways from BROS: creation of The Delaware factor, BELOW)
• Director of corporate opt.. insiders are on a tighter level of scrutiny.. and outsiders are helt to a lower standard. KNOW
HYPOS from BROS
• Suppose that RFBC had shareholders other than Broz and that CIS had a potential interest in Michigan-2, unknown to Rhodes (the seller’s broker), and the ability to finance a purchase. What should Broz have done? PRESENT EVERYTHING TO CIS. THEN RESIGN.
• Suppose Broz had been an officer of CIS, in addition to a director and his RFBC positions. Assuming all other facts remain the same, might that change the analysis or result? Suppose we change the fact that Rhodes, in bringing the opportunity to Broz, didn’t distinguish between Broz’s role in CIS and his role in RFBC? Might that affect the analysis or result? Probably yes.. Closer call.. That may change the analysis makes it a closer call.. If he was also an insider.. Maybe it looks less compelling when he tries to defend himself.
• NEED TO KEEP IN MIDN IF AN INSIDE OR OUTSIDE DIRECTOR.. if we changese t a little his case isn’t as strong to defend himself… NEED TO ASK IF SOMETHING CAME TO SOMEONE IN A RELATED OR UNRELATED CPACITY…
Interlocking Directorate: one person who serves two boards.. there is a relationship now because they have the same director.. unsual to see it when the companies are in the same industry.. usually only works in a highly regulated area…
Delaware’s factors/ Balancing Test to Determine if Corp. Opportunity (See Bross)
1.Is corporation financially able to take the opportunity?
2.Is the opportunity in the corporation’s line of business?
3.Does the corporation have an interest or expectancy in the opportunity?
4.Would taking the opportunity result in a conflict between the director’s self-interest and that of the corporation?
In re EBAY shareholder litigation
- Facts: Ebay officers were getting investment IPO opps from ebays banker, goldman sacks in a common now illegal process called spinning. The officers were making big bucks doing this. Sharehoilders sued. Ebay was also investing in corp opts.
- Question—breach of corp opt? Yes
- Holding- yes. It was a line of biz ebay was in.
1. Company had money to blow. So financially available to take the opt.
2. IN the line of business. Ebay invested in things as well, beyond just the online auction site…
3. As to interest and expectancy.. Ebay should get to make that choice.
4. Lastly it looks like foldman sachs was steering this opps to the inside invenstors.. no one could say it didn’t reate a conlict of interest bc of the money at stake…
- ALTERNATIVE rational is automotive v singer.. agency law. MY BET IS THE EXAM WILL HAVE A DUTY OF LOYALTY Q.. THAT WRAPS IN PARTNERHSIPS AND AGENCY..
CORPORATIONS CAN WAIVE CORPORATE OPPORTUNITY DOCTORINE.
Waiver: DGCL 122(17) explicitly permits corporations to waive the protections of the corporate opportunity doctrine
c. DGCL 122(17): every corporation created under this chapter shall have the power to…
i. 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.
• Remedy: The corporation receives the profits the manager derived from the opportunity, if any
GOOD FAITH, WHICH DELAWARE COURTS HAVE RECENTLY CLASSIFIED AS A SUBSET OF THE DOL
Good Faith
• 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.”
The Evolution of Good Faith in Delware
• Despite the pervasiveness of the concept, it had been essentially undefined until recently. In addition, whether it is an independent fiduciary duty or subsumed in the DOC or DOL had 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. (2006) and Stone v. Ritter (2006)
About Disney:
• Fiduciary duty of good faith can come up in many concepts.. not just exec compensation. What was unusual in the Disney case.. are the specific facts..
• Disney told us: 2 basis for bad faith
o [intentional bad faith] If fiduciary acted with subjective bad faith.. they can make out a sacksful claim of duty of bad faith.. if they intended to harm the corporation.. that is bad faith.
▪ Examples:
▪ (1) If a director intentionally acted with a purpose other than to advance something.
▪ (2) Intent to violate the law
▪ (3) Intentionally failing to act in the face of a known duty o
• THESE are all duties of loyalty no.
o [conscious disregard] However, you don’t have to go that far.. if you could show the intentional dereliction of duty.. a conscious disregard of ones duties.. this counts. Director knows they should do something.. and they are not doing it. Concious disregard. This is worse than being grossly negligent. But gross negligence does not equal bad faith…
• Third added by Stone v. Ritter.. he directors knew that they were not discharging their fiduciary obligations. NOTE: This requirement is added in Stone v. Ritter
Disney (Good Faith in Context Executive Compensation)
• Facts: Disney wooed away Michael Ovitz from CAA and paid him HUGE bucks. Got fired after just a few months with a huge severance package.
- Question: Breach of fiduciary by the board for: DOC? Good Faith?
o –Due Care
▪ What did plaintiff need to prove to show breach of the duty of care? Plaintiff needs to show that they are GROSSLY NEGLIGENT and failed to inform themselves of all info reasonably available.
▪ What did the court suggest would be “best practice”? Court exolainted that if theyd done it well.. all comitte members would have received a spreadsheet from the comp expert would state the amounts that Ovitz received.. and the costs to Disney. For each fo the 5 years of the agreement. Would be the basis of the deliberations.
▪ What actually happened? They met on the general structure, and kenw the value of the event of the NFT… they would be vested and excersizable.. so actual payment was 140M.. if they knew at the time.. no exhibit to the minutes.. witnesses who said spreadsheets were made.. only oral evidence. Got info from 2 sources.. value of benchmark options from others.. and then alaysis from consultant.
▪ Were the directors liable for breach of the duty of care? Court says this ISNT A BREACH… failed to meet best practices bc it says they didn’t know definitlvly the payout amounts. Nonetheless they adequately warned themselves.. and were not grossly negligent in informing themselves.
▪ How is this case different from Van Gorkom? Van Gorkem involved a final period problem.. it was a cash out issue. Huge decision.. bc shareholders were losing their stake. BY contract Disney board was making a smaller decision in relative terms. Even with significant payout it was a smaller decision. The other big ifference is that it seems the Disney board members were not quite as sloppy in their process as the directors in van gorkem were. They had highered a expert consultant.. and had engaged in a process of informing themselves in making decisions..
o Bad faith
▪ Did they act with subjective bad faith? No. Did they intentionally derelect there duty? No.
Summing up Disney re: Good Faith
• Identified two possible bases for finding that directors acted in bad faith:
o Conduct motivated by subjective bad faith (i.e., an actual intent to do harm)
o “Intentional dereliction of duty, a conscious disregard for one’s responsibilities”
o Gross negligence ≠ bad faith
• Gave examples of conduct in bad faith
o 1.intentionally acting with a purpose other than advancing the best interests of the corporation,
o 2.intent to violate the law,
o 3.intentionally failing to act in the face of a known duty to act, demonstrating a conscious disregard for duties.
• The Court in DISNEY. declined to decide whether there is a distinct fiduciary duty to act in good faith independent of the duties of loyalty and care.
What about Non Feasense? For duty of care.. negligence standard easy… for duty of loyalty.. then exculpated with the 102b7 provision.. then you need to show culpability.. need to show not just negligence.. knew something and didn’t do anything. So non feasense becomes really fact specific…
OVERSIGHT- IS THIS DUTY OF LOYALTY? WHAT ABOUT GOOD FAITH?
• It has long been established that the DOC requires directors to pay ongoing attention to the business of the corporation. (Recall Francis)
o Board may rely in good faith on officer and expert reports (DGCL § 141(e))
o Board must become informed of all material information reasonably available (DOC focuses on the process of decisionmaking)
o After which, courts will not question decisions even if they’re substantively bad (this is because of the BJR)
• But what about the quality of information getting to the directors and officers? Do boards have an affirmative duty to assure that a corporate info and reporting system is in place to provide info about legal compliance?
In re Caremark Int’l Inv. Deriv. Litig. [recognized a n action for failing to take minimal steps to achieve legal compliance and provide information to monitor business.]
• 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.”
• This dicta has become what is known as a “Caremark claim,” recognizing a cause of action against boards for failing to take minimal steps to achieve legal compliance and provide information to monitor business.
• 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.
• In Stone v. Ritter, the Del. Supreme Court addressed Caremark’s validity and clarified good faith and how it fits into the fiduciary duty framework.
What might an adequate Law Compliance Program Include?
• Policy manual
• Training of employees
• Compliance audits
• Sanctions for violation
• Provisions for self-reporting of violations to regulators
• Other controls to verify compliance with laws and to give the board the ability to monitor the business
Stone v. Ritter (Good Faith in Context of Oversight).. confirms caremark, says GF is not its own fiduciary duty.
• Facts: Bank that paid penalties that the bank had fiailed to file speicious mony reports.. didn’t comply with the anti money laundering regulations that required the bank to file certain reports.. so it had to pay 50M to the govt. Shareholders brought a derivative suit to recover 50M from the directors.. their thought is why should we pay the fines.. it’s the directors fault.. they breached their fiduciary duty…
• Holding
o Caremark says what the directors need to do…if the (a) failt to implement a control system or (b) failed to monitor the system.
o IN either case.. imposition of liability the directors needed to know that they KNEW they were discharging their obligations.
o Court confirmed a Caremark claim.. but ADDED that the directors knew they were discharging their obligation.. needed to have a known duty to act.
▪ THEN ADDED A KNOWING Failure… HAD A CONCIOUS DISREGARD TO DO SO. INTENTIONAL DERELICTION OF A DUTY TO ACT.. RAISED THE BAR.. MADE IT HARDER TO WIN ON A CAREMARK CLAIM..
o Further says.. Good faith is not its own claim.. is a subsidiary element is a condition of the fundamental duty of loyalty.. is part of a colloquial triad of fiduciary (DOC, DOL, DOGF).. but GF just feeds DOL
▪ COURT SAYS THIS IS A SUBSIDIARY ELEMENT.. IF THEY SHOW A BREACH OF GOOD FAITH.. WHEAT THEY HAVE ACTUALLY DONE THEN.. IS A BREACH OF THE DUTY OF LOYALTY..
o EG
▪ corporate opportunity.. duty of loyalty..
▪ Care mark duty of loyalty.. under good faith..
Caremark Oversight Liability Confirmed in Ritter
• “We hold that Caremark articulates the necessary conditions predicate for director oversight liability:
o (a) the directors utterly failed to implement any reporting or information system or controls; or
o (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.”
Did the Court Re-characterize the Caremark standard?
• Caremark: “[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.”
More on Stone’s Characterization of 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.”
SO THE MDOERN STANDING OG DUTY OF GOOD FAITH
The highlights are:
- Subjective bad faith.. and intent to harm a corporation.
- Or that they acted with conscious disregard.. and intentional dereliction.. bad faith.
- Or maybe they intended to violate the law.. this is also bad faith (disnet)..
- IN addition.. if you breach the duty of good faith.. what you have actually shown is the breach of loyalty.
o THERE ARE ONLY 2 DUTIES… Duty of LOYALTY.. and DUTY OF CARE
Questions
• If Caremark claims are now characterized as good faith and therefore duty of loyalty claims, what other claims should be characterized as violations of the DOL? (Hint: What examples of bad faith did the Court mention in Disney?)
• After Disney and Stone, how would you analyze the decision of a board authorizing corporate employees to break a traffic regulation? Assume the board informed itself and considered the issue and determined it was cost-effective to violate the law and pay the fines.
• Suppose that the AmSouth board had considered the issue and affirmatively decided not to adopt any law compliance program. Would it be liable if that decision resulted in corporate losses? Yes if intent to break the law.
• Does DGCL § 102(b)(7) allow for exculpation of directors for breaches of DOL or bad faith? NO. DOC only.
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.
CONTROLLING SHAREHOLDERS
Duties And Issues Involving Controlling Shareholders
• As a general matter, shareholders have no obligations or duties to each other. They are allowed to act in their own interest in deciding how to vote their shares.
• Where a shareholder is elected to the board, the shareholder becomes a director and in that role assumes fiduciary obligations towards other shareholders.
• Between these two scenarios is the situation of a shareholder with 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.
Controlling Shareholders
• There is not a bright-line rule for determining whether a controlling SH relationship exists; the determination is on a case by case basis: Does a majority of the board lack independence from the allegedly controlling SH
• The notion of a controlling SH includes both de jure control and de facto control.
o De jure: If a shareholder owns more than 50% of the voting stock, then the shareholder has de jure control.
o 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. (Plaintiff bears burden to prove.)
• Although there is no provision analogous to DGCL § 144, the standard of review for corporate transactions with the controlling shareholder has generally been fairness
• One area in which these issues come up is freeze-outs or cash-out mergers in which the minority shareholders are eliminated. Depending on the process, there may be an entire fairness standard or burden shifting and the standard may be lowered...dissenting SHs may also have an appraisal remedy
• Selling Stock: A controlling shareholder is free to dispose of her stock as she sees fit and on such terms as a willing buyer offers (including a control premium).
• Exceptions: a sale of control under circumstances indicating that the buyer intends to loot or mismanage the corporation, the sale involves fraud or misuse of confidential information, the sale is a wrongful appropriation of corporate assets, or the sale is for corporate office (e.g., selling less than majority of the voting stock and receiving portion of $ to put in place a sequential resignation plan for directors).
IMPORTANT NOTE
• There isn’t a single unitary doctrine in this area – there are lines of cases about various contexts and case law varies by jurisdiction. We’ll study:
o Duties within corporate groups
o An overview of some general principles about corporate transactions with controlling SHs and sales of stock by controlling SHs
o Oppression in the closely held corporation
Parent-Subsidy Transactions
- Parents may wholly own subsidies, or there may me parents that own more than 50% and there are minority shareholders.
- Parent company partially owns a subsidiary, and there are minority stake holders.
- Parents may own 100%, but sometimes its possible for a parent to not own 100%.. . generally if one owns 100% then no one is going to complain. But when there is a parent and a sub.. with minority shareholders, this causes an issue. Issue would be if the sub.. is getting controlled only for the benefit f the parent, but to the detriment of the minority..
Sinclair Oil v. Levin- rule for when do shareholders owe duties within corporate groups..
• Facts:
o Sinclaire owned 97% of the stock of sinven, a subsidiary which produced oil in venezwaila. It thus was able to pick the board. They paid themselves 108M in dividends when the company was not profitable, and also contracted with its subsidiary at set rates and then late paid the subsidiary.
o Lower coiurt says breach of fiduciary on both duties.
• Question: was there a breach of fiduciary duty top the minority stake holders? No on the dividends and Yes on the contract to themselves.
• Holding
o Dividends Issue: BJR applies. Sinclair did not violate its fiduciary duty to Sinven by causing the dividends to be paid.
▪ The dividend payments were not self-dealing by Sinclair. Although they resulted in a lot of money changing hands from Sinven to Sinclair, a portion of the money was also received by Sinven’s minority shareholders. There was no benefit to Sinclair that came at the expense of Sinven’s minority shareholders and so the payments do not constitute self-dealing. Accordingly, BJR applies.
▪ Under BJR, the court can find no evidence that the decision to cause Sinven to pay dividends was fraudulent or made in bad faith.
o Expansion Policy: BJR applies.
▪ No self-dealing because Sinven was set up for the purpose of exploring oil opportunities in Venezuela. The opportunities at issue were in Alaska.
o Breach of Contract: Intrinsic Fairness. Sinclair breached its fiduciary duty to Sinven by its role in the formation and execution of the contract with International.
▪ In terms of Sinclair inducing the contract between Sinven and International, Sinclair was engaged in self-dealing, as Sinclair is the parent of both parties to the contract. Moreover, when the contract was breached by late payment, Sinclair was able to reap the benefits of the crude oil to the detriment of Sinven’s minority shareholders. Therefore, intrinsic fairness applies.
▪ Sinclair did not meet its burden of showing objective fairness under that standard. Clearly Sinclair’s involvement is not objectively fair because International breached the contract and Sinclair reaped benefits without fully paying for them.
• What standard applied to each? When there is self-dealing, we use the Intrinsic fairness standard which puts the burden of proof on the defendant to show that their activities were fair to the other shareholder, objectively.
▪ STEP ONE: If a shareholder dominates or controls the corporation…
▪ Step Two: IF THEY RECEIVE A BENEFIT ON THE CORP TO THE EXCLUSION and at the EXPENSE AND DETRIMENT OF THE MINORITY PARTY **USE THIS LANGUAGE ON THE EXAM***… THEN WE GET THE Intrinsic fairness standard.
▪ Step 3: If there is no benefit.. then BJR.
• Notice the difference between intrinsic fairness.
Duties within Corporate Groups per Sinclair
• If a shareholder dominates or controls the corporation, and
• The controlling shareholder receives a benefit to the exclusion and at the expense of the minority shareholders, then
• Burden is on the controlling shareholder to prove intrinsic fairness of transaction.
• Otherwise BJR.
CLEANING of a Controlling Shareholder Action: Controlling shareholder that’s being sued.. owe a duty to show that fair.. can shift the burden away from themselves.. can show if they got a majority of the minority to approve the deal.. this creates cleaning.
Now turning to a different context in which controlling shareholders may be held to have fiduciary duties to protect the interests of minority shareholders….
Oppression in the closely held corporation
CLOSELY HEALD CORPORATION
• Definitions of “closely held corporation” vary, but includes the fact the company’s stock is not traded on a public securities market, and typically they have only a small number of shareholders, who may participate actively and substantially in managing the enterprise.
• Many are small organizations, but they are not necessarily so – some have vast assets and worldwide operations.
• Closely held corporation investors are often connected by family or other personal relationships, and often expect employment by the corporation and a meaningful role in management, as well as financial return on their investment.
• Absent a contractual arrangement, the minority shareholder in a closely held corporation is generally locked into her investment (it is “illiquid”).
o And, unlike an investor in a general partnership, she cannot readily liquidate her investment by exercising a statutory right to dissolve the business.
• Closely held.. often expect employment by the corp.. also expect a financial return o their investment.. if they don’t have a contractural agreement.. they bought stock in exchange for something that they did.. cant sell it on nyse or Nasdaq.. need to have someone willing to buy it..
PLANNING in the CLOSELY HEALD ORPORATION
• Because shareholders in closely held corporations generally cannot exit by selling their shares, they commonly seek to use contracts or internal governance mechanisms to plan for these issues or provide for a voice in the corporation.
o E.g., shareholder voting trusts, shareholder voting agreements, shareholder management agreements, restrictions on share transfers, buy-sell agreement (handout on TWEN)
o Also: employment contracts, supermajority provisions, etc.
SQUEEZE OUTS/ FREEZE OUTS and other OPRESSIONS in CLOSELY HEALD CORPORATIONS
• Without a market into which to sell their shares, minority SHs are vulnerable to board decisions about management, employment, compensation, dividends, etc.
• Controlling SHs have, at times, used various techniques to squeeze out, freeze out, or otherwise “oppress” the minority
o E.g., buy or sell at unfair price to minority SHs
o improperly withhold dividends, improperly terminate employment, management positions, and related benefits >> cut off minority SHs from financial return
o siphon off disproportionate shares of corporate profits by paying themselves excessive salaries, bonuses, benefits, and perquisites
o self-dealing (i.e., commit the corporation to generous contracts with themselves or aligned parties made at less than arm’s length such as with a license to use real or intellectual property, a contract to obtain services from a closely affiliated person or entity, or a loan at nonmarket rates)
FIDUCIARY DUTIES in CLOSELY HELD CORPORATIONS
• Some courts have responded to SH oppression by imposing special or heightened fiduciary duties in closely held corporations, but they differ about when and to whom the duties are owed.
• Many courts have held that controlling SHs have fiduciary duties to deal fairly with and not oppress the rights of minority SHs…
o This includes California. E.g., Neubauer v. Goldfarb, 133 Cal. Rptr. 2d 218 (Cal. Ct. App. 2003); Stephenson v. Drever, 947 P.2d 1301 (Cal. 1997); Jones v. H.F. Ahmanson & Co., 460 P.2d 464 (Cal. 1969) (controlling SHs cannot use their control to benefit themselves to the detriment of the minority without a compelling business purpose).
Wilkes v. Springside Nursing Home (Instrinic fairness standard- look beyond agreement)- no requirement for utmost good faith and loyalty. Balance against selfish rights.
- Facts: 4 partners went in equaly to start a nursing home business. They each got 25% of the business and got equal shares of the profits. They also were able to each to a specific task for the company. This was predicated on getting paid. Needed to do a job. Each received 100 a week. Relationships strained and one of the partners Wilkes was looking to sell out to another partner. There was a board meeting in March, and at the time he was removed of his director duties and any further payments.
- Question: Was this a breach of fiduciary duty og the majority to marginalize a minority stake holder? Yes
- Test applied: Balancing Test: If a legit biz purpose, and if there was an alternate path to get that purpose.
BUT NTOE THAT
- “Important variations occur from jurisdiction to jurisdiction and from case to case.
- If you come in with a small corporations.. and then they get in to disputes.. need to look up the oppression docotinesin a state.. need to look at the rel case law… jdx varys basically..
Nixon v. Blackwell- stands for one corporate law… look at the context and documents.. used an entire fairness standard…
- Facts: Basically owner of Arkansas lumber company.. when died st up an employment funds where the employees owned 25% of the company,, and his family received 75% but had n voting rights. Family was pissed and asked to get voting rights.. court says no.. when one enters into the corporate system.. they have to take it within the confines of the op agreement… different that Massachusetts which applies the fairness balancing test.
- Test Applies: Applied a fairness standard..
- Holding
o “A stockholder who bargains for stock in a closely-held corporation and who pays for those shares…can make a business judgment whether to buy into such a minority position, and if so, on what terms.... It would do violence to normal corporate practice and our corporation law to fashion an ad hoc ruling which would result in a court-imposed stockholder buy-out for which the parties had not contracted . . .”
o The entire fairness standard requires judicial examination of the transaction. This departure from the BJR is justified because business judgment implies “a business decision by a disinterested and independent corporate decisionmaker.” Case law makes clear that stockholders do not have to be treated equally under all circumstances. There is a fiduciary duty of fair treatment, but that does not require equal treatment. There are no special judicial safeguards available for minority shareholders of closely held corporations.
Reconciling the approaches?
- Both approaches seek to enforce what the court assumes to be the parties’ expectations (casebook p. 979)
- Difference in willingness to look beyond the formal corporate documents – should courts interpret fiduciary duties to fill perceived gaps? Or should the court look at what, if anything, the parties have done (e.g. corporate documents and contracts), without creating/imputing fiduciary duties?
Various Options and Remedies
- Some states have allowed for equitable remedies including court-ordered buyout of the minority SH at a fair price, dissolution where necessary to protect the interests of the complaining SHs, etc.
- Some states also have involuntary dissolution statutes. For ex., California’s involuntary dissolution statute authorizes a court to dissolve a corporation where those in control have been guilty of “persistent and pervasive fraud, mismanagement, or abuse of authority or persistent unfairness toward any shareholders.” Cal. Corp. Code § 1800. Majority SHs can avoid involuntary dissolution through a buyout at fair value. Id. § 2000.
- Various options and remedies… sometimes have the majority buy out the minority at a fair price… some will have involuntary dissolution.. but standard is very high.. A court could dissolve a corporation.. exsists..
IF YOU SEE A FACT PATTER WITH A CEO… TREAT THEM AS A DIRECTOR…
Role and Rights of Shareholders
1. Shareholder Voting
• Shareholder duties:
o Generally none, unless controlling shareholder
• Shareholder roles and rights:
o Sell
▪ MAKE A NOTE TO FOR SURE… SAY THAT YOU CAN SELL…
o Vote (& make proposals)
▪ Governing all of this is the fiduciary duty of disclosure. as to this rule.. the BJR rule doesn’t apply.. it means directors can’t lie. They have a duty of candor on things that they are voting on.
o Sue
• plus inspection/information rights
Shareholder Voting Sources of Law and Trends
• State corporation law
o Shareholder voting for directors, on major transactions, amendment of certificate and bylaws
o Fiduciary duty of disclosure/candor
• 1930’s federal securities laws
o Regulates disclosure of information in connection with shareholder voting
o Provides for shareholder proposals (public companies)
• Recent few years—trend toward activism and increasing shareholder power
o Shareholder proposals on majority voting (vs. plurality default)
o Shareholder proposals on proxy access (after D.C. Cir. struck down the SEC’s mandatory rule for this)
o Dodd-Frank’s non-binding “say on pay” voting regarding executive compensation in public companies
o Rising importance of institutional investors and influence of proxy advisors (e.g., ISS, Glass Lewis)
o Shareholder activism
WHO VOTES
• Shareholders of record—the holders on the “record date” vote (DGCL § 213)
o That person can vote in person or by “proxy” (DGCL § 212(b))
o A record date is the date that is chosen.. and the ownership for the stock on that date that corresponds with the voting power of that stock
▪ IMPORTANT ASPECT.. needs to give notice of when the record date is.. Corporation chooses.. no earlier than 60 days before the mtg.. and not 10 days before the mtg. THEY CAN CHOOSE THOSE WITHIN THAT RANGE…
▪ Statute tells company in choosing the record date.. you can chose. 60 days before annual shareholder mtg.. typically what it will do.. it will inform the shareholders what the record date will be for the following year…
• Default rule is one share – one vote, unless otherwise provided in the certificate (DGCL § 212(a))
o Corporation could have classes of stock with different voting rights—e.g., a class could have 10 votes per share—but that must
o be provided for in the certificate of incorporation (vocab: “dual class stock”)
VOCAB ON PROXIES
• Proxys Votes are basically ways to vote as a shareholder without actually being together
• You can also appoint people to vote on your behalf.. called a proxy. Agent 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”
• We have proxy votes for cleansing sometimes.. to help clear up conflicts of interest. This way youc ang et BJR.
QUORUM for SHAREHOLDER VOTING
• How many shares must be present in person or represented by proxy for a valid shareholders meeting?
o Default is a majority of shares entitled to vote (DGCL § 216(1))
o Certificate or bylaws can opt out of default, but never less than ⅓ (DGCL § 216)
• KEEP IN MIND WE ARE LOOKING AT THE SHARES ENTITLED TO VOTE.. NOT SHAREHOLDERS.
WHAT DO SHARTEHOLDERS VOTE ON
- Directors- TO vote in, but not nominate (board nominates)
- Board structure: Classified (“staggered”) board on opt-in basis, if in certificate or sh-approved bylaws (DGCL § 141(d))
• Bylaw amendments, shareholder proposals, non-binding “say on pay”
o Majority of shares present or represented by proxy and entitled to vote* (DGCL § 216(2))
o Must be in the COI
• Certificate amendment - yes
o Directors 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)
o Per applicable statutory provision, generally majority of outstanding shares entitled to vote
• *Note: Remember to first look at what constitutes a quorum and then consider what is the vote required to elect/approve. Also note jurisdictions vary on these rules.
- Remove directors? YES*
i. Stockholders can remove directors for cause (Campbell v. Loews)
1. What is sufficient?
a. Disclosing trade secrets
b. Embezzlement
c. “A calculated plan of harassment to the detriment of the corporation”
2. But, must give notice and reasonable opportunity to respond
ii. DGCL § 141(k): Any director or the entire board may be removed (with or without cause) by the votes of a majority of the shares then entitled to vote at an election of directors, except:
1. COI provides otherwise (then, only for cause)
2. Cumulative voting
a. If less than the entire board is to removed, no director may be removed without cause if the votes cast against such director’s removal would be sufficient to elect such director if then cumulatively voted at an election of the entire board, or, if there be classes of directors, at an election of the class of directors of which such director is a part
- Fill Vacancies? MAYBE
a. Can be done at annual meeting or by written consent
b. DGCL § 223: Unless otherwise provided in the COI or bylaws…
i. Vacancies and newly created directorships resulting from any increase in the authorized number of directors elected by all of the stockholders having the right to vote as a single class may be filled by a majority of the directors then in office, although less than a quorum, or by a sole remaining director;
ii. Whenever the holders of any class or classes of stock or series thereof are entitled to elect 1 or more directors by the certificate of incorporation, vacancies and newly created directorships of such class or classes or series may be filled by a majority of the directors elected by such class or classes or series thereof then in office, or by a sole remaining director so elected.
Voting standard/amount:
o Default is a plurality of votes present or represented by proxy and entitled to vote* (DGCL § 216(3))
o Majority voting on opt-in basis, if in certificate or bylaws (DGCL §§ 141(b), 216)
STRAIGHT VOTING vs. CUMULATIVE VOTING
• In “straight” voting, when a shareholder votes, the # of votes the shareholder has is accorded to each slot that is up for election/being voted upon.
• In “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: Straight voting by default. To allow for board representation of minority shareholders, corporations may adopt cumulative voting for director elections (= opt in). Must be in the certificate. (DGCL § 214)
• California: By default, cumulative voting is available to 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).
Director Elections/ Plurality Examples
• Default is Plurality = whoever gets the most votes for the seat. If multiple candidates for the seats.. whoever gets the most (does not have to be a majority..
• Example 1: more nominees than available seats
o One board seat open for election and 3 nominees: Al, Beth & Carol
o At shareholder meeting, Al receives 35% of votes, Beth 40%, Carol 25%
o Who wins? Beth
• Example 2: single nominee for the seat
o One board seat open for election and 1 nominee.
o At the shareholder meeting, 955M votes against him, 512M votes in favor.
o Does the nominee win the seat? Yes
Majority Voting
• The default rule is that directors win an election by obtaining a plurality of votes. This means that in an uncontested election, a director is elected as long as there is a quorum and she receives 1 vote.
• Some corporations have varied from the default rule and instead require majority voting.
• Majority voting gives SHs (somewhat) more power to control the composition of the board, even without an alternative slate.
• The specific procedures for what happens when a director fails to receive a majority vote vary depending on how the provision is written, for example:
o a strict rule under which the candidate is refused the seat;
o the candidate is required to submit a letter of resignation and the board has discretion over whether to accept it;
o the candidate is required to submit a letter of resignation but only after a replacement director is appointed.
• More than 2/3 of the S&P 500 has adopted majority voting – an increasing trend.
SHAREHOLDER HYPO
• Acme’s directors are A, S, and T (who each own 1 of Acme’s 100 outstanding shares).
• D, who owns 1 share, disagrees with the way A, S, and T manage Acme & wants to replace them.
• D launches a PR campaign against A, S, and T
• urging shareholders to vote against them.
• D is persuasive: All other shareholders send their
• proxy cards, voting against A, S, and T.
• A, S, and T each get 3 votes in favor, 97 votes
• against. A sufficient quorum exists. The default plurality voting rule applies. What result? AST win the board seats.
• What result if Acme instead has a majority voting rule for director elections? They don’t win the seats.. depends what are in the bylaws for what happens nect.
WHEN DO SHAREHOLDERS VOTE?
• Annual shareholder meetings (DGCL § 211)
o A. Can be held anywhere, as designated in the certificate or bylaws
o B. Unless 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 bylaws
▪ Any other proper business may also be transacted at annual meetings
o c) Court can call a shareholder meeting if no meeting was called for 13 months
• d)Special meetings may be called by board, or by shareholders if certificate or bylaws allow
▪ Advance 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
o “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
o (i) the action is by unanimous written consent or
o (ii) the action by non-unanimous consent is exclusively to fill director vacancies (under certain circumstances as specified in the statute)
HOW DO SHAREHOLDERS VOTE?
• They vote either in person or by proxy (DGCL § 212(b))
o Shareholder appoints a proxy (a.k.a. proxy agent) to vote his/her shares at the meeting
o Appointment effected by means of a proxy (a.k.a. proxy card)
▪ Can specify how shares to be voted or give agent discretion
▪ Revocable (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.”
Shareholder Power to Initiate Action
• If shareholders want to initiate an action, how do they do so? What actions can they initiate?
o Amend the certificate? Reactive. First board needs to adopt a certificate. Requiers absolute majority. Adopt a ratification.. Then shareholders vote. Board starts.
o Amend bylaws? Shareholders have a power to amend the bylaws.. Via dgcl 109…
o Nominate directors? Board does this. Most companies have a whole committee of the board.. Who decides who to nominate for the director elections of the seats.. Gives the board a ton of power..
o Remove directors?
▪ What is required? DGCL 141k
• (k) Any director or the entire board of directors may be removed, with or without cause, by the holders of a majority of the shares then entitled to vote at an election of directors, except as follows:
o (1) Unless the certificate of incorporation otherwise provides, in the case of a corporation whose board is classified as provided in subsection (d) of this section, stockholders may effect such removal only for cause; or
o (2) In the case of a corporation having cumulative voting, if less than the entire board is to be removed, no director may be removed without cause if the votes cast against such director's removal would be sufficient to elect such director if then cumulatively voted at an election of the entire board of directors, or, if there be classes of directors, at an election of the class of directors of which such director is a part.
OTHER
• § 141(k): Removal of directors
• § 223: Vacancies and newly created directorships
o If new board positions are agreed to from the certificate of incorporation, a majority of the baod can elect.
o If power is given to the stockholders,
Uncontested vs. Contested Director Elections
• In the ordinary course, board elections are uncontested.
o The company puts up a slate of directors for election and the SHs are expected to elect that slate.
o In uncontested vote.. if the board has nominated people. 1 person 1 seat.. rule is.. the corporation pays for the expenses involved.. sending out the proxies for votes.. different rules.
• Contested elections typically occur in 2 situations:
o In the case of a hostile takeover, the bidding company puts up a full slate of directors that is sympathetic to the acquisition. If the target SHs elect the bidder’s slate, those directors will remove impediments to the takeover (e.g., a poison pill) and vote in favor of the deal.
o Where there is an activist investor who is dissatisfied with management and wants to gain influence over the company. The activist investor might put up a “short slate” of directors, a minority of the board if elected.
o HOW CAN YOU HAVE A CONTESTED IF THE DIRECTORS VOTE WHO GOES UP
- Why contest? If you win? What d you get? Maybe a seat on the board.. votes.. if you lose you may lose a bunch of resources.. but if you win.. you could get a lot of power.
- You only own a certain stake of stock ownership.. that may only be 1 or 2% of the company.. so if you get someone on the board… and they had a better vision.. well they only get 1 or 2% of the upset.. yet they are risking paying the entire cost… bc that’s the caselaw.. we don’t see that many proxy contest or proxy fights
Who Pays for Shareholder Voting and Proxie Contests?
• Rosenfeld v. Fairchild Engine & Airplane
o Facts
▪ 25% stockholder is trying to compel the return of 261k paid out of the corporate treasury to reimburse the company from a proxy contest.
▪ The board members were in a proxy fight for taking the company a new direction.. and basically spent a bunch of money soliciting votes..
▪ They were reimbursed.. and the shareholder was pissed about this.
▪ Court says.. its okay bc shareholders are often indifferent.. so this allows the board to help make sure that things are still moving along.
▪ Expenditures must be reasonable and proper… If they do they send out “no action” letters.. which are not binding law or authority.. but rather guidelines. if its on policy, not personal squabble
So:
▪ Uncontested vote? Corporation pays.
▪ Contested vote? See rosenfeld
o Who pays for incumbents? Corporation. Incumbents are reimbursed for reasonable expenses incurred in good faith.
o Who pays for insurgents/challengers? insurgents.. if they lose.. they do not get reimbursed for the corporation.. they get the burden fo their own cost.. they don’t have to pay ti.. if they win.. though and the incumbent loses.. then the rule is.. these challengers get reimbursed as to reasonable and proper expenditures if the shareholders ratify.. why would you need shareholder ratification.. you do this.. to avoid an INTERESTED DIRECTOR TRANSACTION.. SELF DEALING
• See also DGCL §§ 112, 113
o (providing for bylaws opt-in of proxy access and reimbursement)
o In DGCL 112 and 113… provides for bylaws opt-in of procey access… and reimbursement…
▪ You can customize a companies bylaws.. a provision that opts in to allowing proxy access.. and/or you could not give access to the proy but give some agreement in advance to the bylaws.. for certain types of expenses in running a proxy access.
o To effectively cleans a a proxy fight for an incumbent.. need shareholder ratification.. bc its on both sides of the deal.
Shareholder Proposals
• Shareholder proposals are non-binding on the corporation
a. If a shareholder proposal is included in a proxy statement and the board decides not to implement it, this will be reviewed under the BJR
• Securities laws govern shareholder proposals
• The SEC derives its authority to promulgate rules regarding proxy solicitation from the Securities Exchange Act of 1934 § 14(a)
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.”
NOTE: applicable only to registered securities aka public corporations
so the sec CREATES Enforcement of Section 14(a)
• 14a.. gives rules for how to get on a proxy statement.
• Rule 14a-9 prohibits false or misleading statements or omissions as to a material fact in connection with soliciting proxies
• Public enforcement: SEC can sue for violations of § 14(a)
• Private enforcement (J.I. Case Co. v. Borak (U.S. 1964))
o Private parties have a cause of action for § 14(a) violations
o Suit 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:
o Violation, injury, causation (we will not go into details)
SHAREHOLDER PROPOSALS: Rule 14a-8
• This is about proposals in public corporations.. does not mean that we cant have them apply to private corps.. but it’s a matter of state law.
• To do this… this allows for a proposal to show up on a corporations proxy card..
• Shareholder may include a proposal on corporation’s proxy; expense thus borne by corporation.
• Qualifying shareholders:
o Own at least $2K or 1% of shares
o Owned shares for at least 1 year and hold the shares through the date of the meeting
o Submitted no more than 1 proposal per meeting
• Shareholder or her agent must submit within timing constraints and then appear at meeting to present the proposal.
• Proposal (including supporting statement) may not exceed 500 words.
o You can provide a URL to a bunch of supporting material.. however that may lead to exclusion if that material is materially dales. Need to make sure it complies with the rules itself.
• Corporation may write in proxy statement an objection to the SH proposal (not limited to 500 words).
IN REALITY WHO SUBMITS SHAREHOLDER PROPOSALS?
• Hedge and private equity funds
• Pension funds or other institutional investors
o Union (e.g., AFSCME)
o State and local employees (e.g., CALPERs)
• Individual activists
• Charities/nonprofits
What are proposals usually?
- One is about corporate governance provisions.. adopy a majority voting standard.. or some other governance provision..
- Or it could be that it requests that the company is perhaps a corporate governance.. chairperson of the board to fulfill those functions…
- The other bucket is related to social and political other concerns…
SHAREHOLDER PROPOSAL TRENDS
• 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-discrimination
• Also governance: eliminating takeover defenses (e.g., de-classifying board), majority voting, proxy access, board diversity and independence, disclosure of political spending, separate CEO and chair
CORPORATE RESPONSES TO SHAREHODLER PROPOSALS
• Attempt to exclude on procedural or substantive grounds
o Corporation is required to include the proposal unless can prove to the SEC that it may be excluded under Rule 14a-8
• Include with opposing statement
• Negotiate with proponent
o Wide range of possible compromises
• Adopt proposal as submitted
RULE 14a-8(i) [EXCLUSIONS]
1. Improper subject of action for shareholders under state corporate law (e.g., draft as a nonbinding recommendation (“precatory”))
a. MUST FRAZE IN ANON BINDING WAY. ONLY GIVING A SUGESTION. NON PRECATORY.
b. basically says that shareholders can only do what is empowered under state law.
i. What can shareholders do?
1. Can remove directors
2. Can amend the bylaws
3. And can provide recommendations. However nothing that they can do for recommendations is in a binding way… so if they do phrase it in a way that is binding … the corporation can exclude it on that ground..
2. Violation of law
3. Violation of proxy rules
4. Personal grievance or special interest
5. Relevance: Relates to operations accounting for less than 5% of assets or net earnings/gross sales, and is not otherwise significantly related to the company’s business (see Lovenheim)
i. Otherwise Significant” Test (Lovenheim)
1. Proposal has ethical and social significance
2. Proposal implicates significant level of sales
6. Company would lack power or authority to implement
a. when you cant even do something.. isn’t possible.
7. Relates to ordinary business operations [ SEE TRINITY]
i. Two Part Analysis (Trinity)
1. Discern the “subject matter” of proposal;
2. Ask whether that subject matter relates to the company’s ordinary business operations.
a. If yes, the company must still convince the court that the proposal does not raise a significant policy issue that transcends the nuts and bolts of the company’s business.
i. Does the proposal raise a significant social policy issue?
a. Does that issue transcend ordinary business operations?
8. Relates to director elections (enumerated issues or related to upcoming election)
a. closes the possibility that shareholders could have some proxy access of nominating someone else specific to the board of directors…
b. Not saying that they cant make proposals about governance of elections.. but they cant do thigns that would specifically interseed a specific election…
9. Conflicts with company proposal
a. if propsals directly conflicts with its own proposal in a mtg.. if it says that matter is already
10. Company has already substantially implemented the proposal
11. Duplication
a. The proposal substantially duplicates another proposal previously submitted by another proponent that will be included in the proxy materials for the same meeting
12. Resubmissions
a. Substantially similar proposal has been included in proxy materials in last 5 years and received very little support (3%, 6%, or 10% depending on how many times the proposal has been submitted)
13. Relates to specific amounts of cash or stock dividends
PROCEEDURE FOR EXCLUSION
• Shareholder submits a proposal and asks the corporation to send it out in the proxy
o Proposal can then be submitted for a particular shareholders meeting. Propsoal must be 500 words.. and submitted not less than 120 days before the date of the last proxy statement.
• Rule 14a-8(i) allows the corporation to exclude certain proposals
o If it intends to exclude, it must inform the shareholder of remediable deficiencies and give an opportunity for them to be cured
o It 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)
o When the company notifies the SEC, it usually requests a “no action letter”
o 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)
o Shareholder can try to remedy the defect or could appeal to SEC commissioners or seek injunction in court
Lovenheim v. Iriquois Brands
• Facts: A shareholder sought to include a proposal in the corporation’s proxy statement that related to the corporation’s fois gras business. The corporation excluded the proposal pursuant to the Relevance exclusion under Rule 14a-8(i)
• Holding: The proposal should have been included. The exclusion does not apply because it is not true that the proposal is “not otherwise significantly related to the company’s business”
• Reasoning: Although the operations account for less than 5% of the company’s assets/net earnings/gross sales, it is otherwise significantly related to the company’s business. The term “otherwise significantly related” is not limited by the 5% rule and is not limited to economic
HYPO
Two years ago, Dany Targaryen bought $2,000 worth of stock in Crate & Box, a publicly traded company that sells home furnishings. Which of the following proposals from Targaryen would be excludable under the shareholder proposal rule (Rule 14a-8)?
• (a) A proposal that shareholders elect Targaryen. [no breaches 8]
• (b) A resolution stating that the shareholders desire that the board consider nominating women directors for the board. [Clean.. Too general… for the company to be able to exclude it under number 8.. also frazed in a non precatory way]
• (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. includable bc shareholders can amend bylaws]… and what is the proposal for..? [this is a PROXY ACCESS PROPOSAL].. This is DGCL that allows shareholders to nominate via proxy..
• (d) A proposal that the board sell a particular division of Crate & Box and distribute the proceeds as a dividend. rule 7 could be.. Rule 13… both could exclude.. Specific amount of dividends.
• (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. [likely includable.. Cant be excluded from #5.. Like lvoenheim.. but possible #7…]
Trinity Wall Street v. Wal-Mart Stores, Inc
▪ Facts: Trinity, a shareholder, seeks to put a proposal on proxy statement regarding Wal-Mart’s sale of certain guns.
▪ Holding: The proposal is excludable because it deals with ordinary business. The heart of Wal-Mart’s business is deciding what goes on the shelves.
▪ Reasoning:
• The subject matter is business operations—the way Wal-Mart puts products on its shelves.
• The proposal relates to day-to-day matters of Wal-Mart’s business.
• The proposal raises a significant social policy issue
• But, that issue does not transcend Wal-Mart’s ordinary business operations (“… is how a retailer weighs safety in deciding which products to sell too enmeshed with its day-to-day business? We think it is in this instance. As we noted before, the essence of a retailer’s business is deciding what products to put on its shelves—decisions made daily that involve a careful balancing of financial, marketing, reputational, competitive and other factors. The emphasis management places on safety to the consumer or the community is fundamental to its role in managing the company in the best interests of its shareholders and cannot, “as a practical matter, be subject to direct shareholder oversight.“)
- Holding
o Two part analysis:
▪ (1) discern the “subject matter” of proposal;
▪ (2) ask whether that subject matter relates to the company’s ordinary business operations.
• If yes, the company must still convince the court that the proposal does not raise a significant policy issue that transcends the nuts and bolts of the company’s business
a. Examples of Excludable and Non-Excludable Proposals under Trinity
i. A proposal that asks a supermarket chain to evaluate its sale of sugary sodas because of the effect on childhood obesity should be excludable because, although the proposal raises a significant social policy issue, the request is too entwined with the fundamentals of the daily activities of a supermarket running its business: deciding which food products will occupy its shelves.
ii. So too would a proposal that, out of concern for animal welfare, aims to limit which food items a grocer sells.
iii. Same for proposal that encouraged the pizza franchise to “expand its menu offerings to include vegan cheeses and vegan meats in order to advance animal welfare, reduce its ecological footprint, expand its healthier options and meet growing demand for plant-based foods.”
iv. By contrast, a proposal raising the impropriety of a supermarket’s discriminatory hiring or compensation practices generally is not excludable because, even though human resources management is a core business function, it is disengaged from the essence of a supermarket’s business.
1 5 and 7 are the most used…
- Its on the company decide on the exclusions for which it can apply… they can plead in the alternative.. but its on the company they have to point on what they’ll exclude it on..
- In reconcile 5 and 7 some things may be excludable on one or other.. or both… the analysis for those are separate…
Shareholder Information Rights
1. General Rule: Upon written demand stating the purpose thereof, any stockholder may inspect for any proper purpose the corporation’s stock ledger, a list of its stockholders, and its other books and records. A proper purpose shall mean a purpose reasonably related to such person’s interest as a stockholder.
a. Proper Purposes
i. Communicating with shareholders about interests relevant to stock ownership
ii. Inspection to value shares
b. Improper Purposes
i. Attempting to discover proprietary information for benefit of a competitor
ii. Instituting strike suits (frivolous shareholder litigation)
iii. Fishing expedition
iv. Attempting to discover information for personal business interests
v. Personal purposes unrelated to corporation or shareholder interest (see Pillsbury v. Honeywell)
Shareholder Inspection Rights
- DGCL § 219 Shareholders List
o Available to shareholders for purposes germane to meeting
- DGCL § 220 Books and Records
o Upon written demand stating the purpose thereof, any stockholder may “inspect for any proper purpose” the “corporation’s stock ledger, a list of its stockholders and its other books and records . . A proper purpose shall mean a purpose reasonably related to such person’s interest as a stockholder. . .”
- Recall Disney—“tools at hand”
- A sub aprt of 220 c.. if a shareholder is trying to seek the shareholder list.. the burden is on the corporation tO show they are doing so for an improper purpose…
WHY WOULD A SHAREHOLDER WANT TO INSPECT?
- For potential shareholder litigation
o A stockholder filing a derivative suit must allege either that the board rejected his pre-suit 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 pre-suit demand on the board. (Grimes v. Donald)
- For a proxy contest
o An insurgent/challenger has the tools of state inspection statutes, state voting list statutes, and Rule 14a-7 to help get voting lists or mailing done
What are BOOKS and RECORDS?
- Bare minimum:
o Articles of incorporation
o Bylaws
o Minutes of board and sh meetings
o Board or sh actions by written consent
- What about contracts, correspondence, and the like?
o 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.”
DGCL § 220(c): Burden to Prove “Proper Purpose”--If the stockholder is seeking a stock ledger, the burden is on the corporation to establish that the stockholder is seeking it for an improper purpose. SEE PILLSBERY
State ex re. Pillsbury v. Honeywell [proper purpose is investment purpose not personal grievences]
b. Facts: Shareholder wants Honeywell to stop manufacturing fragmentation bombs for purpose in Vietnam War. The shareholder sought a shareholder list; the corporation refused.
- Question: Is the request proper? No.
o Holding: Under the “proper purpose test”, the burden is on the corporation to show improper purpose. This burden was satisfied. A proper purpose must be germane to the interests of the corporation or the shareholders. Here, the shareholder’s purpose was personal.
If the stockholder is seeking books and records, the burden is on the shareholder to establish proper purpose
Saito v. McKesson HBOC
- Facts: McKesson purchased HBOC. Several months after the acquisition, a series of financial restatements were published. Basically, HBOC had some accounting irregularities that made it so HBOC looked a lot more profitable than it was. Saito brought a derivative action alleging breach of fiduciary duty. Saito, a shareholder, sought records to investigate breach of fiduciary duty and wrongdoing connected to the merger. Specifically, Saito sought documents reflecting financial advice given to McKesson about HBOC. The documents were created before Saito held stock in the company.
- Holding:
- Saito can inspect the McKesson documents regarding financial advice it received about the merger
- Saito is not entitled to inspect the subsidiary’s pre-merger records absent fraud or alter ego. However, Saito can inspect post-merger documents of HBOC.
- Relief is not defeated if there is a second improper purpose. Shareholder must have a proper primary purpose. The ability to get the documents sought will be constrained by the scope for which the shareholder can show proper purpose.
- The date the shareholder purchases stock is not a cutoff date.
- What are the underlying policy rationales?
o It recognizes that shareholders have a legitimate interest that are part of their roles and rights.. engage proxy contests or voting matters..
o Question it’s a cost on the whole corporation.. if required to disclose documents other than the whole shareholder list.. attempt to et clients.. proprietary information for the benefit of a competitor..
o Or someone trying to do their own idiosyncratic goals…
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SHAREHOLDER LITIGATION
• Analysis
a. Should the shareholder bring a direct or derivative lawsuit?
i. If direct…plaintiff sues
ii. If derivative…did the shareholder make demand on the board?
1. If demand was not made… apply the demand futility test (Aronson, Rales)
a. Plaintiff may still face SLC
2. If demand was made… the board must decide whether to accept or refuse demand
a. If the board accepts demand, the board moves forward with the derivative action
b. If the board refuses demand, the refusal is tested for wrongfulness (BJR)
i. If the refusal was wrongful, the plaintiff sues
DIRECT v. DERIVATIVE ACTIONS
Direct:
o Brought by the shareholder in his or her own name
o Cause of action belongs to the shareholder in his or her individual capacity
o Arises from an injury directly to the shareholder
- Types of direct actions
o Protection of financial rights
o Protection of voting rights
o Protection of governance rights
o Protection of minority rights
o Protection of informational rights.
DERIVATIVE
• Brought by a shareholder on corporation’s behalf
• Cause of action belongs to the corporation as an entity
• Arises out of an injury done to the corporation as an entity
• DOC/ DOL CLAIMS
o Harms to the company itself.
o Brought against someone on behalf of the corporation.. by the shareholder. Damages go to the corporation. There is an incentive bc the shareholder can get their money back.
o Usually against the majority or the board members.
Questions on deciding direct v Derivative (per Tooley)
• 1.Who suffered the alleged harm, the corporation or the suing shareholders individually?
• 2.Who would receive the benefit of any recovery or other remedy, the corporation or the shareholders individually?
Tooley v Donaldson – case on what is a derivative action
- Facts: Delay in merger cost shareholders money.
- Holding: This is not a derivative action. There is no injury to the corporate entity. Instead, the complaint (if properly alleged) would set forth a direct claim.
IN order to bring a derivative claim there must be:
- (a) retained ownership by the stockholders
- (b) demand on the board or excuse
- © obtain court approval on any settlement
HYPO
i. ABC Corp entered into a contract with Jane Jones. Jones breached the contract, but ABC Corp has not sued her for that breach. May a shareholder of ABC Corp sue Jones directly?
1. No, must bring a derivative action. The breach did not injure Jones directly. The corporation would receive the benefit of recovery.
ii. ABC Corp’s treasurer embezzles all its money and absconds. Shareholders’ stock is now worthless. May a shareholder of ABC Corp sue the treasurer directly?
2. No, must bring a derivative claim. The injury is to the corporation and it is through that injury that the shareholder is injured (derivatively).
iii. The board of XYZ Inc. agrees to sell 80% 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?
3. Yes, the shareholder can sue to enforce his or her voting rights.
DERIVIATIVE SUITE DETAILS
- To whom does a derivative suit belong? The corp
- Why didn’t the corporation sue in the first place? Bc the directors or majority stakeholders are defendants in the suit..
- Who is really in control of the lawsuit? It’s the lawyer of the plaintiffs attorneys.. the shareholder is the name that’s needed.. usually it’s the other way around..
o Viewed more like bounty hunters.. but there is the potential for good that bring meritorious suits…
- What are the incentives of the relevant parties:
o In bringing a suit? It can solve the problem of having a lot of shareholders but not having everyone motivated to do something.. it allows people the opportunity.. to make an action themselves.
▪ The incentives however are to bring “strike suits” .. just the plaintiff attorney will bring the suit if it gets settled..
o In settling one? The defendents who get sued.. they often will be indemnified against the expenses or insured.. so when they are sued.. they often have an incentive to settle.. they are not paying out of their own pockets.. reputations.. time suck.. etc.. in this realm there is concern that unmeritorious suits will be brought..
COMPETING POLICY CONCERNS
- PRO: Derivative suits are a mechanism of managerial accountability.
o Potential for bias:
▪ Directors cannot be expected to sue themselves.
- CONS
o Cause of action belongs to the corporation.
▪ Like all assets, litigation is under control of the board.
o Shareholder may have interests diverse from those of the corporation.
▪ Shareholders lawyers are often the real party in interest.
o Therefore the board should have some say.
o There will be unmeritorious suits brought.. really belongs as an asset of the corporation…. Not the sharehodlers… may have interests that are actually diverse who may be at it just for the attorneys fees…
MECHANISMS TO MAKE SURE DERIVATIVE LITIGATION IS NOT FRIVOLOUS
- Demand Requirement (Aronson)
- Special Litigation Committees (Auerbach, Zapata, Oracle)
DEMAND REQUIERMENT
- Most states require shareholders to first make demand that the board pursue legal action…unless demand is “excused” as “futile.”
o Must request that the board bring suit on the alleged cause of action
o AT A MINIMUM describe the alleged wrong doer.. describe basis.. and require relief…
- “The demand requirement is a recognition of the fundamental precept that directors manage the business and affairs of the corporation.” Aronson v. Lewis.
- Basic rule: Shareholder plaintiff has to make that demand.. or PLEAD That it is excused as futile… this is demand futility.
WHAT IS DEMAND?
- Typically a letter from shareholder to the board of directors.
o Must request that the board bring suit on the alleged cause of action.
o Must be sufficiently specific as to apprise the board of the nature of the alleged cause of action and to evaluate its merits.
FRCP 23.1/ Ct. of Chancerly Rule 23.1 PROCEEDURAL Rule for Derivative Actions by Shareholders
- Requires that the shareholder:
o retain ownership of the shares throughout the litigation;
o make pre-suit demand on the board or allege with particularity the reasons why demand should be excused;
o obtain court approval of any settlement.
- Note that there are adequacy and standing rules for plaintiffs.
If Demand is MADE?
- If demand is made, the plaintiff-shareholder is deemed to have waived or conceded the right to contest board independence and can no longer argue demand is excused.
- The board may accept or reject the demand—either way, the shareholder-plaintiff loses control of the dispute.
- BJR applies to the board’s decision about the demand/litigation.
- All that is left for the shareholder-plaintiff is a potential argument that demand was wrongfully refused (and they would have to rebut the BJR).
If the Plead for Demand is Excused
- If the shareholder-plaintiff pleads that demand is excused the question is … what is the standard? Demand is excused when “futile”…
- States have different standards… Delaware’s is stated in Aronson and Rales (and California has a similar demand futility standard).
- If the standard is not met, failure to make demand is a procedural barrier and the suit will be dismissed or stayed.
Aronson v. Lewis
- Fink was the 47% stockholder of Meyers parking system. He retired and was given an amazing contract for 10 years consulting services. Plaintiffs were calling this contract corporate waste, fink was 75 years old.. and didn’t think hed do anything. Finka also received loans that had allegedly not been paid back.
- Plaintiffs allege reason for not making demand as:
o A: Defendants participated in, approved, and may be personally liable for the wrongs complained of;
▪ No Good. Basic rule.. BJR…. Unless: Interested transaction Or breach of the duty of care such that BJR doesn’t apply.
• Didn’t show with particularity eacht of these. Need to show some basis.
o B: everyone was subservient to fink.. bc he was the boss
▪ Didn’t plead enough facts with particularity. High stock ownership is not enough.
o C: not going to sue themselves
▪ Said this will never be the standard bc if this was the case then there would never be a determination about this.. This also was conclusory.. they have sufficiently provided allegations to say that they would need to sue themselves.. so this isn’t a free hall pass
Delaware’s Demand Futility Standards (Comes from Aronson)
- Demand is excused as futile if, with particularized allegations, the plaintiff creates reasonable doubt that:
o (1) A majority of the directors are disinterested and independent; or
o (20 The underlying transaction is the product of valid exercise of business judgment.
- = “the Aronson test” for demand futility.
o Applies when the board that would consider the demand made the business decision challenged in the derivative action.
ALTERNATIVE STANDARD for CAREMARK CLAIM OR LACK OF OVERSITE
- There is an alternative demand futility standard in Delaware from a case called Rales v. Blasband.
- Applies…
o In cases not involving a business decision (e.g., failure to exercise oversight claim); or
o Where a majority of the board has been replaced since the challenged transaction with disinterested and independent members.
- Under this test, demand is excused as futile if the derivative stockholder complaint creates a reasonable doubt that as of the time the complaint is filed,
o The board of directors could have properly exercised its independent and disinterested business judgment in responding to a demand.
- Useful for caremark claims.. Also applies where a majority of the board has been replaced since the time of whatever the underlying transaction is. That is that composition of the board has changes so much.. that this board that the complaint would go to.. then it doesn’t make sense to use Aaronson
NOTES
- “Demand is not excused simply because plaintiff has chosen to sue all directors.”
- Discovery limited to “tools at hand”
o DGCL § 220 inspection of books and records.
HOW DOES FRCP and the COMMON LAW MIX?
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SPECIAL LITIGATION COMMITTEE
ABOUT SLC
- In response to a derivative action, a corporation often will form an SLC. The SLC is typically comprised of independent directors who are not defendants in the derivative action. The SLC investigates the claims in the complaint and then recommends whether or not to allow the litigation to proceed. This usually happens at MTD phase.
o This doesn’t happen in every case.. no requirement for a SLC…. But it can chose to do that.. so what does it do..
Auerbach v. BENNETT (NY STANDARD for SLC review.. CA is like this. Look at proceedural)
- Company’s directors were taking bribes. Shareholders sue. They create a SLC and dismiss.
- The court will look at a the SLC if there is a question of it the decision was made of disinterested directors, and the process. Who bared this burden? THE PLAINTIFF.
o Form of BJR… they have not informed themselves and that the members of the Members were not independent and acting in good faith.
- This looks at the actual investigative process.. but it won’t look in to the substantive decision: did they meet.. did they higher outside council.. did they do a process that looked like they informed themselves?
Zapata Corp v. Maldonado
- Facts: Maldonato a stockholder of Zapata initiated a derivative action against the 10 officers/ directors for breach of fiduciary duties… Maldonado did not first deamand from the board to bring this action. By the time the action was brought 4 directors were off the board, and an investigation committee had been created by 2 board directors… SLC pushed to dismiss.
- Question: does this committee have the power to cause the action to be dismissed?
- Holding
o Section 141(c) allows a board to delegate all of its authority to a committee. Accordingly, a committee with properly delegated authority would have the power to move for dismissal or summary judgment if the entire board did.
o Issue of power thos, if the board just gives BJR, possible issue with trampling sharteholders.
o So they use a 2 step test… this is in DEMAND EXCUSED CASES
▪ Step 1 a procedural inquiry.. this is an inquiry into the independence and good faith of the committee and the bases supporting its conclusions…
• Limited discovery may be ordered to facilitate such inquiries..
• Corporation has burden of proving independence fo, good faith, and reasonable investigation…
▪ Step 2.. substantive inquiry..
• If the court applies its own BJR.. as to weather the motion to dismiss should be granted..
DELAWARE STANDARD FOR SLC RECOMMENDATIONS PER ZAPATA
- “Zapata Two-Step” in demand-excused cases:
o Step 1: Procedural inquiry
▪ Inquiry into the independence and good faith of the committee and the bases supporting its conclusions
• Limited discovery may be ordered to facilitate such inquiries
• Corporation has burden of proving independence, good faith, and reasonable investigation
o Step 2: Substantive inquiry
▪ If the court is satisfied with the above, the court may go on to apply its own business judgment as to whether the motion to dismiss should be granted
REVIEW TWO APPROACHES TO SLCs
- Auerbach (NY): Procedural not substantive scrutiny of SLC
o SLC decision covered by BJR
o But judicial inquiry permitted with respect to:
▪ Disinterested independence of SLC members
▪ Adequacy of SLC’s investigation
o Burden of proof on plaintiff.
- Zapata (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.”
o States differ in which approach they follow.
o California has adopted an approach to SLCs similar to NY.
1. “Independent” Directors
c. Aronson Approach
i. The plaintiff must “demonstrate that through personal or other relationships the directors are beholden to the controlling person.”
d. In re Oracle Approach
i. The question of independence turns on whether a director is, for any substantial reason, incapable of making a decision with only the best interests of the corporation in mind. The independence test ultimately focuses on impartiality and objectivity.”
1. “…in my view, an emphasis on ‘domination and control’ would serve only to fetishize much-parroted language, at the cost of denuding the independence inquiry of its intellectual integrity.”
e. In re Oracle Corp. Derivative Litigation
i. Facts: Members of Oracle’s board are charged with bad faith failure to monitor and insider trading
ii. Holding: Court denies Oracle’s MSJ because there is a genuine issue of material fact as to the SLC’s independence. The ties between the board members and SLC members could substantially affect the independence of the directors (example of family members investigating each other)
iii. Reasoning: Although SLC members seemed independent based on the report (low compensation, etc.), there were significant personal ties between them. Boskin and Grundfest were both senior fellows at SIEPR, Ellison had contributed to SPIEPR and Stanford, etc.
Recap on Shareholder litigation
- Shareholders can sue to hold directors and officers accountable. Misconduct or harm to the corporation.
- Claims can either be direct or derivative.
o If Direct suit, really just as simple of bringing it forward directly. Can do so individually or in a class. This is just a normal lawsuit.
o Dirivative litigation is a SPECIAL matter of corporate law. It is the main mechncaism by which a claim for breach of fiduciary duty is taken forward.
▪ It is the corporation that has been injured. And it’s the shareholders trying to get the corporations to sue the real defedent.
▪ With derivative suits, there are potential and significant obstacles.. there is a balance between understanding the litigation or the claim belongs to the corporation itself. Yet because of the special circumstances that arises when a corp is managed by a director who may be the defedents, these obstacels are created to maintain that we really should put the trust in the directors.
▪ We are balancing of who should be in control of the suit.. that should be in the hands of the board of directors. So the demand requirement under 23.1… the result is that the plaintiff would have to show that the this demand was futile..
• Need to look at which states law applies for demand futility. Aaronson and rales to decide.
• If not futile, then they must make demand at the board, and at that point it is the boards discretion what to do on that demans, and then they get BJR.
• If futile, they get to continue on in that suit.. they may constitute a special litigation committee.. to make a destermination weather they want to bring it or not.. Zapata 2-step. Oracle case application of this. To weather their committee are independent and that they use a reasonable investigation and did so in good faith. BEYOND this the court in Delaware can also decide if it applies its own BJR to decide if it shoud let it go.
Indemnification and Insurance
Idemnification
- 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 indemnification. And they specify payments that corporations must not indemnify (prohibited).
- Directors aren’t agents taken.. so no right to indemnification technically.. the way that these statutes are written.. they will have some provisions that are mandatory.. they know when someone must idemnidy for something.. and also specify certain payments that may be prohibited..
IDEMNIFICATION AND INSURANCE
• General Rule: Depending on the circumstances, a corporation may indemnify directors and officers against judgments, amounts paid in settlement, and attorney’s fees
o NOTE: Directors are not agents. Therefore, directors cannot be indemnified under agency principals.
o Policy: encourage people to serve as directors
o The default rules regarding indemnification are found in DGCL § 145
o However, the statute is not exclusive and does not bar other rights to indemnification through bylaws, agreement, vote of stockholders, or otherwise (DGCL § 145(f))
o In addition, a corporation may buy insurance with coverage broader than permissible indemnification (DGCL 145(g))
▪ Does this make sense? Through insurance, a corporation could cover amounts paid in settlement for derivative claim.
• Mandatory Indemnification
o DGCL § 145(c)
▪ Where a director or officer
▪ 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
o Who decides whether to indemnify?
▪ DGCL 145(d):
• By a majority vote of the directors who are not parties to such action, suit or proceeding, even though less than a quorum; or
• By a committee of such directors designated by majority vote of such directors, even though less than a quorum; or
• If there are no such directors, or if such directors so direct, by independent legal counsel in a written opinion; or
• By the stockholders.
o DGCL § 145(a) – Does not apply to derivative suits
▪ A corporation can indemnify directors, officers, employees, or agents of the corporation for…
• Judgments
• Fines
• Amounts paid in settlement
• Expenses
• Attorneys’ fees
▪ Provided that…
• 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
• In a criminal action, the person had no reasonable cause to believe the person's conduct was unlawful.
o DGCL § 145(b) – Applies to derivative suits
▪ A corporation can indemnify directors, officers, employees, or agents of the corporation for…
• Expenses (including attorneys’ fee) actually and reasonably incurred in connection with the defense or settlement of the action
▪ Provided that…
• 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
▪ Exception: If the person is judged to be liable, then no indemnification unless the court approves it
• Prohibited Indemnification
o DGCL 145(e) – Advancing Litigation Expenses
▪ Expenses incurred by an officer or director may be paid by the corporation in advance if the officer/director promises to repay the money if it is determined that they are not entitled to indemnification.
• Expenses (including attorneys' fees) Incurred by an officer or director of the corporation
• In defending any civil, criminal, administrative or investigative action, suit or proceeding
• May be paid by the corporation in advance of the final disposition of such action, suit or proceeding
• Upon receipt of an undertaking by or on behalf of such director or officer to repay such amount if it shall ultimately be determined that such person is not entitled to be indemnified by the corporation as authorized in this section.
• Such expenses (including attorneys' fees) incurred by former directors and officers or other employees and agents of the corporation or by persons serving at the request of the corporation as directors, officers, employees or agents of another corporation, partnership, joint venture, trust or other enterprise may be so paid upon such terms and conditions, if any, as the corporation deems appropriate.
• Director and Officer Insurance
o All, or nearly all, public corporations carry D&O insurance. A large percentage of private companies do.
▪ But, often expensive and difficult to obtain
o Policies may have high deductibles, maximum coverages, and/or exclusions (ex. for reckless conduct, intentional torts, violation of certain types of laws, etc.)
o Some corporations establish trust funds to pay damages or expenses
o Three parts:
▪ Side A: Executive Liability
• Pays directors and officers directly for loss when corporate indemnification is unavailable
▪ Side B: Corporate Reimbursement
• Pays the corporation for any money it has paid as indemnification to the insured directors and officers
▪ Side C: Corporate entity coverage for securities claims
• Attorneys’ Fees in Derivative Actions
o Plaintiff’s attorneys in derivative actions seek payment of their fees from the corporation using one of two rationales
▪ Common Fund Theory
• Applies when the action produces a monetary recovery for the corporation
• Unjust enrichment if plaintiff had to pay all legal costs
▪ Substantial Benefit/Common Benefit
• Must show that by bringing the suit, the plaintiff conferred a substantial benefit on the corporation
• Courts liberally construe “substantial benefit”
o Includes even if there is a settlement, even if there is no monetary recovery, etc.
- To calculate, use lodestar or other method of recoveryThere is ALSO permissive indemnification. It is possible for a director/agent to be indemnified.
o 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)
o § 145(a)
▪ –Indemnification in what types of actions?
▪ –Who is covered?
▪ –What is indemnified?
▪ –Standard? Deemed to act in good faith and reasonably believe that they weren’t opposed to the corp interest.
o § 145(b)
▪ –Indemnification in what types of actions?
▪ –Who is covered? Agent officers. Etc.
▪ –What is indemnified? Permissive for EXPENSES including attorneys fees.
▪ –Standard. Same as A.. good faith. Reasonably not opposed to the corps interest.
• If there is a claim in which someone.. end up showing that you’ve breached a fiduciary duty.. it can only be permissivly indemnified if a court approves it.
o § 145(d): How is the permissive indemnification decision to be made? Who makes it?
▪ A majority of disinterested directors. Or can have a majority of shareholders. Or can have a court approve it. Or have an independent or special legal council. This is a matter to get someone unbiased so you don’t have self-dealing.
o § 145(e): Why would D and Os care about this provision?
▪ Upon the recipt of an undertaking by such director or officer if it shall be ultimately determined, then they can get an advanced. An undertaking is a document that says they promise to trpay the amount if they are deemed to have not been indemnified in the situation. Allowed, but not required.
o §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 used public policy considerations to set outer bounds though).
▪ The statute is one set of rules, but it can be supplemented by the corporations actions. This gets used a lot.. bc directors and officers want to know upfront how likely they are to get indemnified.
▪ The
o §145(g): A corporation may buy insurance with coverage broader than permissible indemnification.
▪ Allows a comrporation to buy insurance that is broader than permissible idemnidiaction..
▪ –Make sense? Yes.. this is all aprtof the machinery.. it lessons the instances when you have defedents pay out of pockets for things. Made van gorkem crazy to have people liable… to pay out of pocket..
• Since van gork 12 bt..
o People still will ask for indemnification agreements… as a belt and suspenders.. but these statutes exsist.
- The economics that underly this litigation. Often the defedents are paying out of their own pockets, so they often settle.
D and O Insurance
▪ All, or nearly all, public corporations carry D & O insurance, and a large % of private companies do.
o 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.).
o If a really big judgement the insurer wont cover all of it. And the rest goes to the corp.
o There are also sometime exclusions in an insurance policy. Things that may get excluded are bad faith conduct.. and there is a finding in bad faith.. similarly illegal conduct.. bad faith.. fraud.. typical for exclusions.
▪ Some corporations have established trust funds to pay damages or expenses.
o This happens whens corps cant get insurance.
HOW d and O insurance works
- Commonly has different parts:
o An executive liability part (“Side A”), which pays directors and officers directly for loss (including defense costs) when corporate indemnification is unavailable;
o A corporate reimbursement part (“Side B”), which pays the corporation for any money it has paid as indemnification to the insured directors and officers.
o Corporate entity coverage for securities claims (“Side C”).
- •To 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.
o Attorneys fees get paid by the corp as well.
o SO it is typically the insurance that pays the attorneys on both sides.
ATTORNEYS FEES
- Plaintiffs’ attorneys in derivative actions seek payment of their fees from the corporation using 1 of 2 rationales:
o “Common fund theory”—where the action produces monetary recovery
o “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 construe
• Us loadstar.. and then.. plaintiffs attorneys get paid through LOADStar and or meeting the ability to give a substantial benefit for a benefit.
- Computation based on either lodestar or percentage of recovery methods
WHY INVESTMENTS
- Mutually agreeable settlement territory
▪ DandO may not cover enough. Litigation is a hassle. If we cang et it early dismissed.. or settle.. and on the shareholder plaintiff side.. the plaintiffs attorneys will only want to go to trial is greater than their expected time and value and fees.. if the lawyer is not going to think litigation is attractive if you cang et money now quickly.. so yous eea lot of settlements.
o “I’ll be good from now on”
o Governance changes (cosmetic?)
o Perhaps a payment (from whom?)
- •Recitation that suit conferred “substantial benefit”
- •Recitation that directors acted in good faith
- –Plaintiffs’ lawyer gets paid, directors covered by indemnification and insurance
JUDICIAL APPROVAL OF SETTLEMENTS
- Courts purportedly consider a wide range of factors in deciding whether to approve a settlement, including
o –(1) the maximum and likely recovery;
o –(2) the complexity, expense, and duration of continued litigation;
o –(3) the probability of success;
o –(4) the stage of the proceedings;
o –(5) the ability of the defendants to pay a larger judgment;
o –(6) the adequacy of the settlement terms;
o –(7) whether the settlement vindicates important public policies;
o –(8) whether the settlement was approved by disinterested directors; and
o –(9) whether other shareholders have objected.
- Sometimes courts wont.. accept the payments.. and will not accept settlements. But usually they wil. Only if really not fair.
- These suits are thought of as only benefitting the lawyers. SO dirivitative litigation seems self serving.
- Modern view is it plays an important role.. still a lot of shareholder suits.. there is a real finding in breach fo fiduciary duty in some form.. weather it is sufficient to help the corporation is up for debate. 305% of suits provide relief to the corporation. And those that get relief.. ththey are usually higher than the cost of attorneys fees. SO net positive.
- Strike suits are down. WAHTS A STRIKE SUIT.
- 10b5 is down, however bc there has been a rise in security frauds suits.
o Why? 10b5 actions don’t have demand requierements not as many obstacles. Dirivative litication obstacles are high. Attorneys have thus not shifted to these securities suit.
SECURITIES FRAUD AND INSIDER TRADING
- There is a big universe of securities fraud. This is just one type.. a claim of material misrepresesison aor omission in ocnecction with the sale of security.
FEDERAL SECURITIES STATUTES
- Trading it takes place on 2 basic types of markets
o Primary market
▪ When a corp issues stock and you buy directly
o Secondary market
▪ Or you buy from existing stock holders
- There was trading in stock long before there was securities laws. IN the 1900s blue skys laws were passed in the states. Then there was the stock crash.. which prompted federal regulation.
- Opassed 2 acts:
o Securities Act of 1933 [focused on regulating the primary market]
▪ –Regulates the sale of new securities
▪ –Disclosure at the time of the public offering
▪ –Definition of “security”
• Needs to register that stock. Dinfed security.
• Security is a term of art: A security is defined in the 33 act to include stock notes bonds investment contracts.. and then also investment contracts that is equity like. Courts have reuled famously that a variety of thigns are securities.. investments in worm farms and orange groves.
• NEED TO KNOW: Security means MORE THAN stock. If you have a question about it.. LOOK IT UP. Need to find out. It may be a security.
o Securities Exchange Act of 1934 [secondary market regulation]
▪ –Regulates secondary trading activity
• Annual basis and quarter basis reporting. See below.
▪ –Requires periodic disclosures by public companies
▪ –Created the SEC
▪ –Notable sections:
• •§10(b) Anti-fraud
• •§14(a) Proxy solicitations and shareholder proposals
• •§14(e) Tender offers
• •§16 Short-swing trading by insiders
EXCAHNGE ACT 10(b) SECURITIES EXCHANGE ACT – BIGGIE. NO misrep or omission.. to make sale or purchase of security.
- 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—
o (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. …
- THIS IS MADE TO GIVE SEC POWER TO MAKE THE RULE.
SO the SEC.. uses this language to create 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,
o (a) To employ any device, scheme, or artifice to defraud,
o (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
o (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
- in connection with the purchase or sale of any security.
o BROAD FRAZING.. TO APPLY TO PUBLIC OR PRIVATE SECURITIES. Has been a HUGE AMOUNT OF CASE LAW NTERPRETING.. justice reinquist is a judicial OAK that has grown from a legislative acorn.
WHO CAN BRING 10b-5 SUITS?
- “It shall be unlawful for any person. . . ”
o –DOJ: Can bring a criminal action where there is a willful violation (see Securities Exchange Act § 32(a)).
o –SEC: Can bring a civil action and can recommend that the DOJ bring a criminal action.
- –Private parties:
o No express cause of action.
o 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.
Conduct that violates 10b-5
- Securities fraud or deception
o –See, e.g., Basic v. Levinson; Tellabs v. Makor Issues & Rights
- Insider trading
o –Classic
o –Tipper-tippee
o –Misappropriation
NOTES on 10b-5
- Actions claiming 10b-5 violations must be brought in federal district court.
o –State claims can be added under pendent jurisdiction.
o –Exception: Class actions that also allege state corporate law breach of fiduciary duty breaches under state corporate law can be brought in state court.
- 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
PREREQUS for a 10b-5 action
- PREREQUS
o Jurisdiction
o Standing and transactional nexus
- ELEMNTS
o Material misrepresentation or omission
o Scienter
o Reliance
o Causation
o Economic loss (damages)
PREREQUS FOR 10b5 CLAIM
1. JURISDICTION
- 10(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…”
o Tie in to the constitution. Easy to meet usually.. usually involved interstate commerce.
- Usually 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.
o Bc the phone could be used for interstate commerce.
- (Just beware of tricky fact patterns that somehow don’t involve any instrumentality of interstate commerce…)
2. STANDING AND TRANSACTIONAL NEXUS (In connection with the purchase or sale of any security
- IN connection with means.. touch and concern with the sale. No NEED FOR PRIVITY.
o Priving no need means even if its only need the behavior to affect the transaction.. just needs to affect. Doesn’t need to be trading in the stock. Usually a suit against a corp..
- Rule 10b-5: “in connection with the purchase or sale of any security”
- –The deception/fraud must be “in connection with” a securities transaction.
o The Court has explained that it need only “touch and concern” the purchase or sale.
o There is no requirement of privity; it applies even if not a party to the transaction so long as the behavior affects transactions.
- – Only purchasers or sellers have standing to sue. **** BIGGIE (birnbaun doctorine)
o This is known as the Birnbaum doctrine after a 2d Cir. case.
o The Supreme Court affirmed the purchaser-seller requirement in Blue Chip Stamps v. Manor Drug Stores.
o 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.
▪ Plaintiffs decision not to buy or not to sell. Doesn’t give one access. NEEDS TO HAVE BOUGHT OR SOLD…
▪ Would have opened the finality claims.. I would have.. no deal with maybe issues..
HYPO
On behalf of Mining Co., a public corporation, the CEO issued a statement that the corporation was experiencing average or below average productivity levels. The CEO knew that the situation was in fact significantly better because of a recent major mineral discovery on the edge of its land, that it had begun to exploit. The CEO had a legitimate desire, however, to acquire additional nearby leases for Mining Co. before it revealed its mineral discovery.
She decided not to buy bc of the statements. Standing? None. Not buying.
10b-f Defendents
- Weather other actors like lawyers an accountants can be aiders and abbetos. Rule is.. that aiding and abetting for giving substantial assistance is only available if it’s the SEC that is bringing the suit.
o 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). In private actions, the defendant must be a “primary violator” whose statements or omissions induced investors to trade.
- Rule 10b-5 has no privity requirement.
o –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.
ELEMENTS TO 10b5 CLAIM
- “In a private securities fraud action the plaintiff must prove the defendant (1) made materially false or misleading statements (2) with an intent to deceive (3) upon which the plaintiff relied (4) causing losses to the plaintiff.”
- This is a species of fraug.. about securities. Simial type of elements.
1. Material Misrepresentation or Omission
- Basic v. Levinson ( TW ELEMENTS MATEIAL..P
- FACTS
- Basic was a publicly traded corporation Combustion had been interested in acquiring Basic for ~ 2 years; beginning in Sept. 1976, Combustion reps had meetings and conversations with Basic D & Os about a possible merger. Deal rumors circulated, but Basic consistently denied them:
• –Denial 1: Oct. 21, 1977 (stock price at $20)
• –Denial 2: Sept. 25, 1978
• –Denial 3: Nov. 6, 1978
- Acquisition announced Dec. 19, 1978 – priced at $46/share. Plaintiff class: Investors who sold stock between Oct. 21, 1977, and Dec. 19, 1978 before announcement
- –CLAIM “they were injured by selling Basic shares at artificially depressed prices in a market affected by petitioners’ misleading statements and in reliance thereon.”
- ISSUES
- 1.Were Basic’s statements materially false?
- 2.Is this a proper class action, when proof of reliance is an issue?
- General standard of materiality? “whether there is a substantial likelihood that a reasonable shareholder would consider the fact important” TSC Indus., Inc. v. Northway Inc. (1976)
- But how do we apply this standard when faced with uncertain and contingent facts? “a highly fact-dependent probability/magnitude balancing approach”
- OF IT AN MOVE A STOCK PRICE.. DEFENITLY MATERIAL.
- PROBABILITY LIKELYHODD VS HOW BIG..
1. THINK ABOUT.. BASICALLY HIGH CHANCE.. AND THEN low effect material. Or big effect and low chance.. still material..
- Footnote 17: Silence Duty to Speak, Duty to Update
- “Silence, absent a duty to disclose, is not misleading under Rule 10b-5.”
- –“‘No comment’ statements are generally the functional equivalent of silence…” fn. 17
- There is no duty of continuous disclosure under federal securities law.
- When does a duty to speak arise? If you chose to speak.. then you are not materially false or misleading. The rules about when a duty to speak arise.. when defedents have whats referred to a relationship with trust and confidence with the plaintiff.. an actual filing obligation with the SEC..
- So what they should have done wen asked is say NO COMMENT.. absent a duty a speak. This is interpreted as not materially misleading..
1. AN omission is when you leave something out.. that makes what you did say misleading…
2. Scienter
• PSLRA requires pleading with “particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”
• State of mind required = intent to deceive, manipulate, or defraud
–This means the defendant was aware of the true state of affairs and appreciated the propensity of her misstatement or omission to mislead.
–Supreme Court left open whether recklessness suffices for scienter.
• Circuit courts have recognized that reckless disregard of the falsity of a statement suffices for scienter.
• Circuits define recklessness differently; e.g., where the misrepresentations were
NEED INTENT OR RECKLESNESS IS ENOUGH.. not pure negligence…….
• Tellabs v. Makor issue and rights 9not as big as basic v levison but big case).. most famous for scianter…
o Facts: How to interoperate the pleasing requirements of scienter.. what wasn’t clear was having to show that at a level of strong inference..
o Need to state with particularity.. in making a false or misleading statement.. what is a strong inference.. ?Favorable inferences between.. look at all the facts.. if everything collectively.. not any individual… must be at least as compelling as another competing inference…
o At the trial is more likely than not… needs to be atleast as compelling…
o What the court did here..so then it remanded back to the 7th ciruit..
o PSLRA was designed “to curb frivolous, lawyer-driven litigation, while preserving investors’ ability to recover on meritorious claims.”
o PSLRA heightened pleading instructions, requiring that the complaint “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind” in making a false or misleading statement.
o Key issue: What counts as a “strong inference”? How must a court approach that determination?
1. Reliance
- Reliance must be reasonable
- Reliance is presumed in omission cases if the undisclosed facts were material
• – Affiliated Ute Citizens of Utah v. United States (1972)
• Why not prove? Too hard to prove that someone didn’t rely on something. SToo slippart.
- But what about misrepresentation cases? Easy to show.
• –And won’t reliance be difficult to show for each plaintiff in a class action?
• –See Basic (& recent Supreme Court case Halliburton)
- What is the “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 misrepresentation
- One way of satisfying the reliance requierement. It’s a rebuttable presumption.. when relying on the trading of the market device.. giving this rebuttable presumption of reliance.. itsunderstood to reflect the publically available information… this comes from the efficient capital market hypothesis.. its possible we have a workd where we have the strong form.. that the price would reflet all information about the company. Both inside and out. We don’t have that world.. we know we don’t have that world.. is bc insiders can insider trade.. but ppl with quibbles think we live in a semi strong perfect capital maket.
- This allows for classactions.. bc it makes a rebuttable presumption.. it shows that it overcomes the common issues.. this ruling in basic v levinson.. was incredibly important..
Rationale/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 misrepresentation
- The stock traded in an efficient market
- Plaintiff traded the stock between when the misrepresentations were made and when the truth was revealed
- How can it be rebutted? If there are enough rumors that enough information know the truth.. they don’t let the price get to the truth.. if the specific plaintiffs would have bought or sold stock anyways.. then they didn’t rely on the integrity of the market… nd then if the tok wasn’t actually trading on an open and efficient market
Reliance
- How can a defendant rebut the fraud on the market presumption?
2. Causation
Two Types of Causation
- Transaction Causation
o Closely related to reliance
o But for the fraud, plaintiff would not have entered the transaction or would have entered under different terms
- Loss Causation
o Akin to proximate cause
o The fraud caused the plaintiff’s loss
o E.g., show a change in stock prices when the misrepresentations were made and then an opposite change when corrective disclosures were made
o If 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 causation
1. Really have to have experts give testimony. The type of experts are economist.. and others that do event studies.. that measure weather there were cumulative cha ges from the material misrepresentation..
2. Causation is usually presumed.. but loss causation has to be shown.
More on Causation
o Some courts treat transaction causation as equivalent to reliance. In particular, where reliance is presumed, courts will also assume transaction causation is met.
o Omission cases
o Where there is a presumption of fraud on the market
o Loss causation is not presumed
o Plaintiff must show that he suffered losses as a result of his reliance
3. Economic Loss (Damages)
Possible remedies and damages..
- Rescission: in face to face transactions
- Possible to get discorgment if relevant.
- Out of pocket damages is the typical.. typically have a class action who have been harmed.. experts will testify to.
- PSLRA caps famages at difference between the transacted price and the average of the faily prices during the 80 day erio after corrective isclosure.
SECURITIES FRAUD AND INSIDER TRADING
• A. Securities Fraud and Rule 10b-5
• B. Insider Trading
o 1.Rule 10b-5 and Classic Insider Trading
▪ Chiarella (S. Ct.)
• 2. Tipper/Tippee Liability
o Dirks (S. Ct.)
o Salman (S. Ct.)
• 3. Misappropriation Theory
o O’Hagan (S. Ct.)
o C. Section 16(b) Liability for Short Swing Trading
[pic]
CLASSIC INSIDER TRADING
Chiarella v. United States [ex of classic]
- Facts: Guy who was printing information found out a company was going to be purchased. Bought stock.. and profitied 30k. Was investigated by the SEC for criminal charges. Bought shares in the target company tha was to be bought. Lower court said guilty. Appealte said guilty. Supreme court said not guilty and overturned the ruling
- Question: ISSUE ALSO COULD BE STATED ON WHAT TYPE OF INSIDER TRADING CONDUCT CAN VOLATE 10-b-5
- Holding
- CRUX OF HOLDING not in statute but via case law..
• “[O]ne who fails to disclose material information prior to the consummation of a transaction commits fraud only when he is under a duty to do so. And the duty to disclose arises when one party has information ‘that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them.’”
1. This isn’t necessarily ACTUAL FEDUCIARY DUTIES.. but incorporates PRINCIPLES.. and abstractions of that..
- Statute doesn’t inherently say if silence is a fraundelent activity. But through caselaw we find that a corporate insider must abstrain from trading or disclose all info. IF THEY HAVE A DUTY. A duty is found by
• 1. The exsistance of a relationship affording access to inside information intended to be available only for a corporate purpose and (
1. Says there is no relationship. No direct entrustment or fiduciary duty given to the printer. So no duty.
2. Says to find a duty would put a general duty on everyone. Too burdensome.
3. The misappropriateion theory had been … denied.. bc not argued. Could go the other way.
• WASN’T MISSAPPROPRIATION BC HE TRADED IN ANOTHER PERSONS STOCK… IF IT WAS IN THE STOCK HE HAD A DUTY TO.. POSSIBLY MAYBE..
With classic theory.. need to ask
- Is there an insider?
- And are they trading in their own corporations stock? On the basis on non disclosed.. material information.
- If yes and yes then go..
WHO MAY BE LIABLE?
• “Insiders”
o Directors and officers
o Agents
• Temporary/constructive insiders?
o Corporate counsel, accountants, underwriters, consultants, etc.?
• Tippers and Tippees?
• Other people? Outsiders?
TIPPER TIPEE CASE: Dirks v. SEC
- Facts: DIalusioned former corporate insider told of how the company was fudging its numbers to a stock broker. The stock broker told his clients as well as the WSJ.
- Question: did the tippee do insider trading? N.;
- Holding
• DIRKS ON 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.”
4. Dirks established who can be defedents.. it established who can be a constructive insider.. accountants.. lawyers.. taking in information only for a orporate purpose.. and to kee it confidential.. treated as insiders for 10b5 analysis…
•
Tipper Tippe liability
• 1.The “tipper” will be liable if she discloses info in breach of a duty, which occurs when she discloses for a personal benefit.
• 2.The “tippee” acquires the tipper’s duty to disclose or abstain from trading if the tippee knows or should know that there has been a breach, and the tippee trades or causes others to trade.
DISCUSSION QUESTIONS
• Had Secrist disclosed the info to Dirks for a personal benefit? it’s a personal benefit.. exchanging stock tips.. quid pro quo. Recipricle information.
• What if Secrist had routinely exchanged stock tips with Dirks?
• What if Secrist had disclosed the Equity Funding fraud in part because he had been fired over an unrelated matter?
• Suppose Secrist had disclosed inside information to Dirks because of a bribe from Dirks. Dirks then advised his clients to sell their Equity Funding stock. Dirks would have violated Rule 10b-5. Would his clients also have violated the rule?
Who can Be a DEFEDENT
• Dirks established a category of “constructive insiders”
• When does someone become a constructive insider?
Barry Switzer hypo
Barry Switzer claimed that when he was sitting in the bleachers at his daughter’s track meet, he overheard a CEO telling his wife that he would be out of town the following week because the CEO’s company might be liquidated. Switzer and his pals traded on the information.
Insider trading liability? NO
NOTE ON FINANCIAL ANALYSIS
• Role of financial analysts
• Regulation FD, adopted by the SEC in 2000
o SEC concluded that selective disclosure to analysts undermined public confidence in the integrity of the stock markets
o SEC concluded the Dirks tipping regime inadequately constrained tipping because of difficulty proving the tipper received a personal benefit from the disclosure
o “Reg FD” restricts selective disclosure of MNPI by someone acting on behalf of a public corporation
▪ If 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 news
▪ Intentional disclosures must be disseminated simultaneously; unintentional disclosures within 24 hours or start of next trading day on NYSE
• Note on financial analysis.. play some role in making a market efficient.. this role is inconsisten.. equal access.. why they should be able to treat some analysis..
• Evidence that corporate managers were using access.. they would were coercing analysis by threatening to withhold info they didn’t like.. nice coverage theyd give them information.. this corrupts the analayst community.. this caused them to start doing something called regulation FD.. makes one of disclosure.. not insider trading.. relevant regulation to note.. not teathered to 10b5.. but slsective disclosure of non public info..
o
Salman v. United States
- Facts : 2 bros.. Michael and maher.. in 2002.. slmans future bro in law.. joined citi groups investment baking grou.. from 2004-2007.. regularly disclosed on upcoming mergers and acquisitions of on citigroup clients.. meanwhile.. maher became marries to salman sister… nbrother and brother in law.. started sharing.. series of trades to try and hide it.. brokerage records showed salaman executed identical trades.. who was passing on material non public information.. and Michael pled guilty and testified… tipper to tippee to sub tioee
- Holding
o To get 10b5.. to get the info.. the tippee needs to get info that is material.
o Says dirks holding still apply.
o Mahers discloser of material non public info to Michael knowing that Michael was going to trade on it.. and even instances where the brother offered to give him money, and instead he just wanted the info.
o This is precisely the gift of confidential informaitont hat dirks imagined.
o Maher himself had testified that by giving Michael insider info to fulfill whatever needs he had.
o As to Salmans knowledge.. Michael.. had testified.. that he directly told salman that the information was coming from his brother maher..
o Effectively overturned.. made newmans bad law… bc the US supreme couty affirmed Dirks…
o So Salman is another illustraition of the Dirks rule of the tipper tuppe of the liability.. context is the original dirks case was a whistle blower.. this is a contrasting case in which the discloser of material non materials was for a non disclosing benefit.
Misappropriation Theory
Misapropriation is broader than classical.. basicaly is an exception hat swallows the rule.
Rule 14e-3
- Prohibits insider trading during a tender offer and thus supplements Rule 10b-5.
o 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.
o 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.
- The rule also prohibits people from tipping… also heald liable.
o O’Hagan upholds it anyway.
Misappropriation Theory: US v. OHagan
Facts: Took place in minniapolis.. representing a client called Grant met.. was considering a tenderoffer of pillsbury. Eventually the firm withdrew. Why representing.. ohagen became aware of the tender offer.. wasn’t his client.. was the firms client but he heard about it. He put in some calls.. that he was going to profit if the stock went up. And also bought shares direct.y He ended up makinf 4.3M in profit. Ohagen was a partner at this firm.. and then grand met…
o Why not tipper tuipee? Bc he wasn’t tipped.
o Classical wont cover this. Bc wasn’t buying stock in grand met.. was buying in pilsbury. Would have had to buy in gran met to get that it apply.
- Holding
o Misappropriation was valued.
o Acted on MNPI.. and was deceptive in his trading. He owed a duty to Dorsey and white and also grand met. Bc it hurts them in a long run.
o How do you know when someone had a duty to the source… court gives us some info…
▪ By being in a partnership.. owed a fiduciary duty to the clients..
▪ Bc it was a law firm.. ethical codes on how ti shoud be treating client information.
▪ Actually owed a duty to both…
How could ohagen have avoided 10b5 liability—don’t trade that helos avoid it. Wht about a disclosure to the sourceof the information??????... this is a situation where disclosing to the source of this information…
- If you tell the source.. you are no longer being deceptive… to the source.
- Theres a footnote.. that suggests a duty is owed where its owed to multiple parties.. there re 2 sources of info where a duty is owed to ohagen.. to lawfirm.. etc, Would need to have disclosed to sources of information.. to not be violating 10b5… if you only disclose to one of the two.. there would still be one source (the sources are the firm and the company that the firm is working for.
o COPORATE OPPORTUNITY DOCTORINE..
o STILL BE RBEACHING A FIDUCIARY DUTY.. CONFIDENTIALITY AGREEMENT.. 14E3… IF TIS ABOUT A TENDER OFFER… EVEN IF NOT 10B5….
AFTER OHAGEN THE SEC ENATED RULE 10B5-2
Misappropriation Theory 10-b-5
Defendant misappropriates MNPI in breach of a duty owed to the source(s) of the info.
- How do we determine whether the defendant had a fiduciary duty?
o Does the corporation expect the outsider to keep the information confidential?
▪ O’Hagan: Lawyer’s ethical codes, Lawyer’s position/role
▪ Other (non-exclusive) guidance: Rule 10b5-2
- How could O’Hagan have avoided 10b-5 liability?
o Abstain from trading
o Disclosure to the source of the info; public disclosure not required
o Practical impact:
▪ Disclosure vs. consent; federal vs. state law
▪ Rule 14e-3?
THESE ARE 3 EXAMPLES THAT EACH OF THERE COULD BE A DURTY OF TRUST OR CONFIDENCE.
o IF SOMEONE AGREES TO MAINTAIN INFO IN CONFIEDENCE. DON’T HAVE TO BE ACTUAL FIDUCIARY. JUST NEED CONFIDENCE.
o WHEN PPL HAVEA HISTORY APTTERN OR PRACTICE.. WHEN PEOPLE SHOULD NOTE WHEN TO KEEP THIGNS REAOSNABLY CONFIDENTIAL..
o WHENEVER THE INFORMATION IS OBTAINED FROM A SPOUSE PARENT OR SIMBLING… THIS CONSTITUTED A DUTY OF TRUST
Rule 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; or
3. 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.
What is Rule 10b5-1?
- 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.
What is a 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.
Insider Trading Penalties
- Civil:
o Injunction
o Disgorgement of profits
o SEC can seek treble money sanctions, up to 3x profits realized or losses avoided
▪ Because the SEC can seek disgorgement and treble damages, an inside trader thus faces potential civil liability up to 4 times profit gained.
o Administrative proceedings for regulated market professionals (censure, suspension or revocation of broker/dealer licenses, etc.)
- Criminal:
o Prison up to 20 years
o Fines up to $5 million fine for individuals; $25 million for corporate defendants
Section 16(B) Liability for Short Swing Trading
Short Swing Profits
- Exchange Act § 16
o (a): Reporting obligations
▪ “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.
o (b): Bright-line short-swing trading rule (over- and under- inclusive for insider trading)
▪ “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”
Highlights
- Strict liability that requires disgorgement to public corporation of profits made:
o Within a 6 month period
o By certain insiders & “beneficial owners”
- Intent is irrelevant
- Will compute profit in a way that produces the maximum possible number
- § 16 applies only to officers, directors, or shareholders with more than 10% of the stock
o Officer: SEC definition includes president, CFO, chief accounting officers, VPs of principal business units and any person with significant “policymaking function.”
o Stock classes are considered separately
o “Deputization”: If Corp X authorizes one of its employees to serve on the board of Corp Y, and Corp X profits on Y stock within a 6 month period, Corp X may be liable under § 16(b).
- Directors and officers:
o You cannot match a transaction made prior to appointment to one made after appointment.
o 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:
o § 16(b) liability only if she owned more than 10% both at the time of the purchase and of the sale.
▪ See Foremost-McKesson v. Provident Securities
• Issue: Can we match the Oct. 20 acquisition with the Oct. 24 disposition?
• Conclusion: No. “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”
• Holding?
o In a purchase-sale sequence, the transaction by which the shareholder crosses the 10%+ threshold is not a matchable purchase
o Regarding beneficial owners, only transactions effected when one is a more than 10% shareholder are matchable
More Highlights
- § 16 applies only to companies that must register under the Exchange Act = public companies
o Companies with shares traded on a national exchange (e.g., on NASDAQ or NYSE), or
o 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)
o Compare Rule 10b-5, which applies to all issuers (regardless whether public or private)
- Equity Securities
o § 16 applies to stocks, convertible debt, and options to buy or sell (a “call” or “put”)
o Compare Rule 10b-5, which applies to all securities
- Sale and Purchase
o Sale and purchase
▪ § 16(b) applies whether the sale follows the purchase or vice versa
▪ Courts interpret the statute to maximize the gains the company recovers
▪ Hence, shares are fungible for purposes of § 16(b)
• If the trader sells 10 shares of stock and then within six months buys 10 shares of stock in the same company at a cheaper price, he or she is still liable
▪ But the sale and purchase must occur within six months of each other
- Recovery
o Any recovery goes to the company
o § 16(b) profits can be discovered through SEC filings
o Shareholders can sue derivatively, and a shareholder’s lawyer can get a contingent fee out of any recovery or settlement
o Statute of limitations = 2 years
HOW to approach a 16(b) Issue
- 1. Is the company public?
- 2. Is the defendant a director, officer, or beneficial owner of the company?
o 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.
o Beneficial owner - only if she owned more than 10% both at the time of the purchase and of the sale, and within 6 months.
- 3.Can you match any purchase and sale within a 6 month period that yields profits?
o Buy low and sell high
o Sell high and buy low
LLCS
a. Overview
- LLCs are their own unique form of business organization. They are not partnerships nor corporations.
o 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.
o Tax advantages (can choose to be taxed like a partnership or a corporation; partnership = pass-through tax)
o Limited liability like corporation
- A hallmark characteristic of LLCs is flexibility.
o They are premised on a notion of private ordering. A LLC is “as much a creature of contract as of statute.” (RULLCA § 110 cmt.)
o Except as expressly limited by statute, the “operating agreement” sets the rules for the L
- LLCs are as much a feature of contract as they are of statute.
iii. State LLC laws vary widely.
1. Each state has its own LLC statute.
2. There is a uniform statute, RULLCA, adopted by over a dozen states (incl. California).
3. LLC case law is developing, but is generally much less extensive than partnership and corporate case law because LLCs are relatively new.
iv. The “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 disputes
LLC notes in CA
- Licensed professionals cannot operate through LLCs in California.
- In choosing between form of business, consider tax and fee issues.
o E.g., California has a “gross receipts fee” that apply to LLCs (but not corporations); depreciation deductions; etc.
o For more info on taxes:
b. Formation
v. Choose state of organization and reserve the LLC name
1. Internal affairs doctrine applies to LLCs
vi. Draft articles/certificate of organization consistent with statutory requirements and file with the Secretary of State, paying filing fees and the franchise tax.
1. Check the statutory requirements for what is required for articles of organization
2. Typically required:
a. The LLC’s name;
b. The LLC’s purpose;
c. The agent for service of process;
d. A description of the type of business that constitutes the principal business activity of the LLC;
e. 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.
vii. Tax arrangements (state and federal)
1. LLCs can opt to have pass through taxation
viii. Designate office and agent for service of process.
ix. Draft and enter into an operating agreement.
1. The Operating Agreement is the basic contract governing the affairs of a LLC and stating the various rights and duties of the members, including:
a. Each member’s units/interests in the company
b. Rights and duties of the members (including management structure and rights, voting rights and requirements)
c. The manner in which profits and losses are divided, and distributions are made
d. Amendment of operating agreement (default is unanimous consent)
e. Remedies in the event that the members disagree on the direction of the company
f. Exit provisions (e.g., withdrawal, dissociation, admission) and dissolution
2. In California all LLCs are required to have an LLC Operating Agreement (code § 17050)
x. In California, file a “Statement of Information” with the Secretary of State, within 90 days after filing the articles of organization (and update as required).
Articles of Organization
- Check the statutory requirements of what is required and file with Secretary of State’s Office
- E.g.:
o the LLC’s name;
o the LLC’s purpose;
o the agent for service of process;
o a description of the type of business that constitutes the principal business activity of the LLC;
o 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 AGREEMENT
- The basic contract governing the affairs of a LLC and stating the various rights and duties of the members
- E.g.:
o Each member’s units/interests in the company
o Rights and duties of the members (including management structure and rights, voting rights and requirements)
o The manner in which profits and losses are divided, and distributions are made
o Amendment of operating agreement (default is unanimous consent)
o Remedies in the event that the members disagree on the direction of the company
o Exit provisions (e.g., withdrawal, dissociation, admission) and dissolution
- In California all LLCs are required to have a LLC Operating Agreement (code § 17050)
c. Limited Liability and Veil Piercing
xi. General Rule: 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)
xii. Exception: Courts have imported “veil piercing” concepts into LLC law.
1. Courts have pierced the LLC veil of limited liability to reach the personal assets of members under circumstances similar to those under which courts would pierce the veil of a corporation.
a. Is this a good idea? Should the test be the same?
d. Management Rights
xiii. Variable Management Structure: LLCs can be either member-managed or manager-managed and can customize governance
xiv. Member-Managed
1. Default Rule
2. Most matters (ordinary course of business) are decided by majority vote
3. States vary regarding whether the default allocation is one-person/one-vote or by ownership interests in the company (percentage or units)
4. Significant matters require unanimous consent
a. E.g., merger, admission of new member, amending the operating agreement, etc…
xv. Manager-Managed
1. Can be structured as a committee, “board of managers,” a CEO, etc.
2. 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)
e. Finance
xvi. Contributions
1. LLC statutes do not require any minimum amount of capital to be contributed to an LLC
2. Members need not make capital contributions
3. Members are free to decide among themselves how much cash, property, or services, if any, each member will contribute.
xvii. Allocation of Profits and Losses
1. Typically provided in the operating agreement.
2. Delaware Default: Allocate profits and losses on a pro rata basis per the ownership interests in the company (percentage or units) (DLLCA § 18-503).
3. RULLCA does not provide a default
xviii. Distributions
1. Refers to the transfer of LLC property (e.g., cash) to members.
2. Members have no statutory right to compel a distribution (distribution rules governed by operating agreement)
3. When a distribution is declared, statutes usually have 1 of 2 default rules:
a. Distributions on a pro rata basis per the ownership interests in the company (percentage or units) (e.g., CA § 18-504).
b. Equal share rules (per capita) like partnership (e.g., RULLCA § 404).
xix. Transferability
1. Unless otherwise provided in the LLC’s operating agreement, a member may assign her financial interest in the LLC.
a. Such a transfer typically transfers only the member’s right to receive distributions and does not confer governance rights or rights to participate in management.
b. An 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.
c. Analogous to partnership rules.
f. Fiduciary Duties
xx. Manager-managed LLCs
1. The managers of a manager-managed LLC have a default duty of care and loyalty*
2. Usually, members of a manager-managed LLC have no duties to the LLC or its members by reason of being members
xxi. Member-managed LLCs
1. All members of a member-managed LLC have a default duty of care and loyalty**
xxii. The standard of care varies by statute
1. Some state an ordinary care standard, some state gross negligence (e.g., RULLCA)
xxiii. Derivative Actions
1. Member 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 so
xxiv. Freedom of Contract
1. RULLCA permits modification, but not elimination, of fiduciary duties (“manifestly unreasonable” standard).
2. Some states (like Delaware) have allowed for elimination of fiduciary duties if clearly and expressly provided in the operating agreement.
3. The implied contractual covenant of good faith and fair dealing is non-waivable. (RULLCA allows the operating agreement to prescribe standards, if not manifestly unreasonable, by which the performance of the obligation is to be measured)
g. Dissociation and Dissolution
xxv. RULLCA
1. RULLCA’s dissociation and dissolution default rules are similar to the RUPA rules
2. Exceptions:
a. The unilateral withdrawal of a member does not result in a dissolution;
b. No default provision for a buyout upon dissociation (instead the dissociated member holds interest as a transferee)
c. RULLCA specifies different events by which a member can dissociate and also means of expelling a member (including where a member transfers all her interest)
3. Effect:
a. LLCs more stable than partnerships. Similar to corporations.
b. It is more difficult for one member to force dissolution and winding up
4. NOTE: Importance of customized rules in an operating agreement
xxvi. Delaware
1. Delaware provides default rules for dissolution upon any of the following:
a. At the time, or upon the happening of events, specified in the operating agreement;
b. Unless otherwise provided in the operating agreement, upon the vote or consent of members who own more than 2/3 of the then-current percentage interests in the LLC;
c. Within 90 days of an event that terminated the membership of the last remaining member (with limited exceptions); or
d. Upon the entry of a decree of judicial dissolution.
2. Unless otherwise provided in the operating agreement, a member cannot unilaterally resign or withdraw until the LLC has been dissolved and wound up.
h. Issues to Consider When Choosing Business Form
xxvii. Formality
1. How formal do the parties want the relationship to be?
xxviii. Ability to raise capital
1. Will the business want to raise capital by selling securities in the near future?
2. What business forms are investors comfortable with?
xxix. Which default rules do the parties prefer?
1. 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?
2. Is limited liability important?
3. How will the business be managed? How will control be allocated?
4. How long do the parties expect to stay in business together?
5. Do the parties want their interests to be freely transferable?
xxx. Taxation and fees
1. Which form of taxation do each of the parties prefer (based on their own income, goals, expectations about future revenue/assets)?
2. Filing fees, franchise fees, gross receipt fees?
DIFFERENCES
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• SOCIAL ENTERPRISE (E.G., BENEFIT CORPORATIONS)
a. L3Cs
i. New form of for-profit business entity (low-profit LLCs with a charitable or educational purpose).
ii. 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.
iii. The L3C form was passed by 9 states, but has slowed and even regressed.
b. Benefit Corporations
i. New form of for-profit business entity.
ii. Legislation varies by jurisdiction; is available in California, Delaware, and some other states (~30 currently); is on the rise.
iii. Most statutes are based on a model statute proposed by B Lab, a nonprofit corporation that awards certification.
iv. Benefit Corporation vs. B Corp
1. Benefit Corporation: specific legal corporate structure
2. B Corp: a certification by a third-party certifying company
v. General Rule: In making business judgments, the directors must consider the impact of their decisions on non-shareholder interests (e.g., the environment, society).
vi. A benefit corporation must:
1. Have a corporate purpose that involves creating or pursuing “a public benefit” (= “a material positive impact on society and the environment”; some statutes define differently)
2. Produce, 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.
3. Assessment must be done by reference to a comprehensive, credible, and transparent third-party standard.
4. Must 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.
5. “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.
a. Remedy? Removal of director?
b. No case law on how courts should analyze these proceedings or how the fiduciary obligations should be assessed.
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